The following is a guide on how to manage money and risk when trading the stock market.
Money Management & Risk Control Rules:
1. What is the maximum percentage amount you are prepared to risk losing on any one trade?
a) as a % of total Account size?
A sound rule to follow here is the “2% Rule” which states that you should not risk more than 2% of your total account on any one trade. That means for a 100K account, the maximum you can risk per trade is $2K. If you wanted to put 20K on a stock, you would have to find a suitable trade where the maximum risk is no more than 10% as determined by your stoploss.
You may tweak this percentage up and down a little to suit your own risk tolerance and account size but I would strongly advise against anything over 5%.
b) as a % of any one trade?
Generally 5 – 10% is a common trade risk. If the trade shows an enormous potential, up to 20% may be acceptable. In such case, you would put 10K on the trade to satisfy the 2% Rule for a 100K account.
2. What is the maximum no. of stocks you will hold in your portfolio at any one time?
You want to diversify but at the same time, focus your capital into a handful of the most promising stocks. Otherwise your returns will be comparable to those of a fund manager.
3. What is the maximum amount you will invest in any given trade as a percentage of your total trading account?
You should never place more than 25% of your account on any given trade even if the 2% Rule shows more. For example, if you find a trade that has a 5% risk and you have a 100K account, placing 40K on the trade by following the 2% Rule is too much. So you would cap your position in such a case to a maximum of $25K.
There is no such thing as a dead cert in this game so never plunge on one or two stocks. Have an absolute maximum amount you are prepared to bet on any one trade, and learn to harvest your winnings consistently over time, to grow your portfolio.
4. How will you maximize your returns in a winning position?
To generate significant growth in your portfolio requires placing sufficient capital on your trades. A good strategy is to pre-figure your desired maximum position and pyramid a winning position up to it. For example with a 100K account, if you wanted to enter a trade that had initially a 20% risk, purchase 10K worth of shares and as the trade moves into profit, tighten your stoploss and buy additional 2 or 3 progressively smaller parcels at higher prices until you build your total desired position in the stock.
5. Risk to Reward: Ask yourself “is the trade you’re considering worth the potential reward?”
If you’re risking 2K on a trade that has the potential of making 10K, than you’re probably fine. But if you’re risking 2K and the potential reward is 1K, you would have to seriously question the viability of the trade. So again, have a rule in place, for example, to only consider making trades where the Risk to Reward Ratio is at least 1 to 3.
6. How will you vary the size of your bets to optimize portfolio growth?
Many traders never produce optimum growth in their portfolio because of not properly sizing their positions. They either risk too much or too little on each trade. As your account grows, so must the amount you invest in each trade. Otherwise your equity may increase or decrease to the point where the current amount you put on each trade becomes proportionately too large or small to be a good bet. And this will reflect in the shape of your equity curve.
To grow your portfolio without large swings in equity requires gradually increasing the size of your bets. As your trading account grows in value, add more money per trade. If your account decreases during losing streaks, add less per trade. How is this done? The same way as everything else when it comes to trading – by following Rules, or in this case, my super simple formula:
P = (A*R)/S
P = Number of shares to buy next trade (max. 25% account)
A = Account Balance in dollars
R = Max. percentage of total account you are prepared to risk losing on any one trade (the 2% Rule)
S = Difference between your entry price and stoploss price in dollars
Example – A 100K trading account and using the 2% Rule. Trade entry at $10.00 and a stoploss at $9.00
A = 100,000
R = 0.02
S = 10.00-9.00 = 1.00
P = A*R/S
= 2000 shares to buy.
You can tailor this formula to suit your own risk tolerance. If you feel risking 2% of your account on a trade is too much, use less, say 1%. Now as your account balance grows, you add more for your trades. If it decreases, you add less. By varying your position size with each trade win or loss, this approach will let you grow your account with discipline and confidence.
My trading blog Sharesmadeeasy provides free education to stock traders and investors.