As discussed previously, when it comes to trading stocks the second most important thing after having a basic framework for understanding value and trends in the market is practicing sound risk management. This is because trading, like all human endeavors, does not follow any sort of strict physical laws. Not only is price influenced by emotions like fear, greed and pride, but it is also influenced by routine life events like routine sales to fund retirement spending, or to record gains/losses on taxes. Even the experts often make bad calls and it is important to protect yourself from getting hurt too bad when you’re wrong.
To that end, one rule of thumb is the 2/6/10 rule. The ‘2’ stands for 2%, which is the most any one trade should hurt your portfolio if you’re wrong. For instance, if you have a $100,000 portfolio and put everything on one stock, if that stocks causes you to suffer a $2,000 loss you must exit. Or, if your $100,000 is broken up into five positions at $20,000 a piece, then every trade can lose $400 before you exit, or four of the five can gain and while one position suffers a 10% loss of $2000 before you exit. This rule becomes more powerful and flexible the more you divide your money between several positions. Once you’ve found and tested a workable trading system, odds are you will be correct more often than you are wrong and this rule will stop you from risking too much on any one bet. (See my monthly updates for Exhibit A of this!) The smaller your positions too, the more you can let routine price volatility push them in one direction or another before you have to act. This can keep you in the game when you might otherwise panic and exit at a bad time.
The second part of this equation is ‘6’ or 6%. This is how much of your portfolio you can lose in a month before you must stop trading. The reason for this is to stop you from destroying yourself by over-trading in a bad market. If you have a reliable system in place that proves correct more often than not, and you are still losing 6% a month, its time to step back and take a breather. The market is trying to tell you that things are going on beneath the waves that you don’t understand and that you shouldn’t enter the water again until you do.
10 stands for 10%, which is the percentage you should allow any one stock to turn again you before exiting the position. There are two reasons for this. First, prices go up and down regularly. When you see great swings in price, this is called high volatility. When prices won’t move at all, this is low volatility. Either way, volatility exists and you need to know what you risk tolerance is and at what point you should abandon a stock. At 10%, you will not freak out at every twist in the market and get whipsawed out of a position, but at the same time you will avoid the 20-30% swings that can cripple a portfolio.
This leads to the second reason that this rule exists, which is that losses happen and ar easy to overcome – if they’re small. For example, if your position is down 10% you need an 11% gain in order to return to your original value. However, if you are down 20%, you need a 25% gain to make it back. With a 30% loss you need a 45% return and it only gets worse from there. Since it is highly unlikely that you will see such returns, you should never put yourself in the position in the first place of hoping against hope. If a stock travels 10% beyond your expected price, get out.
As you can see, each one of these three components is extremely helpful in avoiding bad loses while trading stocks. However, their real power comes into play when you use all three rules simultaneously! If you have a position size small enough that a 10% move against you won’t cost 2% of your portfolio, and that it would take several such extreme swings to reach 6% of your total, then it would be extremely rare for an experienced trader with a dependable system to suffer grievious loss. To put it another way, if you have enough shields to deflect a blow, the spear will seldom reach you. If you can thus keep winning month after month, year after year, then eventually your wealth will start to snowball.
It is important to keep this in mind because the hardest part of a good risk mitigation strategy is that it keeps your position sizes smaller than you’d like and limits extreme profits. It sucks, but that’s the way the game works, and the extent to which you break these rules is equal to the extent that you’ll get burned. (just look at me!) That is one of the primary reason that professional traders recommend that newbies have an account size greater than $200,000 if they ever hope to actually “trade for a living”, because otherwise they will not have the risk controls in place to survive and the profits that you make will be too small to live on without a day job. That is also one of the reasons why I have an eventual goal of reaching a $500,000 portfolio. What feels like an extreme hardship with a small account is much more satisfying when you can still pull off $5,000 or $10,000 or $20,000 wins using smaller, diversified positions.
In conclusion, this is only a taste of the art of risk management. I didn’t even begin to touch upon the many debates surrounding stop-loss orders and other techniques! I hope that this piece will inform your trading, help you trade better, and encourage you to learn more about the subject.