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Limiting Risk, Using Position Sizing, Setting Stops
  

Most stock traders trade a fixed number of shares or simply trade as many shares as they can afford.   They think of all the money that they can make with even a small price movement with all those shares and seldom have any idea of what they are risking,   Since they don't even want to think about losing money, few will have any sort of exit plan in case the trade goes wrong.   It is well known that nearly all new traders lose.   Examination of beginning trader mistakes indicates that the most common reason for losing is risking far too much on each trade.

Let's examine the idea of risk before moving on to bet sizing.   Ralph Vince* once did a study in which 40 PhD's played a game with positive expectancy, in fact there was a 60% chance of winning each bet.   Each participant started with $1000 and was allowed to bet whatever he wished on each game.   After 100 games all but two players had lost money and many had lost everything.   How in the world is this possible and what does it tell us about human nature?  

First, the participants varied their bet sizes.   They tended to bet more after a few losses and less after a favorable run.   It's human nature at work: say the first three bets are losers and you have bet $100 each time.   Now you are down to $700 and you think, "since I've had three losses in a row and the odds are 60% in my favor, I'm sure it's time for a win."   So you bet $400 this time but as luck would have it, you suffer another loss.   Now you have only $300 and your chances of recovering your losses are slim.   Playing the game mentioned above with a small, fixed size bet will all but guarantee a profit - betting $50, for instance, will win $200 after 100 bets - yet the PhD's lost.   The second problem was that most risked far too much on each bet.   Let's examine what can happen with excessive bet size.   Let's say that you bet $250 each time and happen to lose four times in a row.   The probablity of this happening at any particular time is small but the probability is that it will happen at least once in the 100 bet game.   If you are even or behind when it happens, you are broke - in fact, chances are you will be broke before the fourth loss.

In each case, failure to understand and control risk led to a loss in a game that was mathematically a sure thing.   Failure to understand and control risk means that even after a winning streak, eventually you will lose most - or all - of your capital.   Consider: if you lose 25% of your capital on a trade you must then gain 33% to get back even.. and if you lose another 25% you find that you must now double your money, that is- make 100% on what is left, just to break even.   Things can get out of hand very quickly if the risk is excessive.  

The point here is that you can have a winning strategy and still lose money if you fail to control your risk.   The secret to making money with that winning strategy is in these three simple rules:

Risk only a very small amount of your capital on each trade

Risk the same amount on every trade

Set reasonable profit goals based upon the risk amount
(Take only trades with a reasonable chance of reaching those goals)

We suggest that the trader risk no more than 1% of his capital on any single trade.   At this risk level the trader can reasonably expect to be able to weather the storm of a losing streak and let the percentages work for him.   (Regardless of what the 1% figure might be, the Risk must be an amount that we can live with, an amount that will not bother us unduly if we lose.   If we are "trading scared" we will end up trading the money instead of the chart.)

What is risk in a stock trade?   If we buy 100 shares of a $20 stock what is our risk?   It is most definitely not $2000 unless we are foolish enough to hold it until it becomes worthless.   Our risk is the amount that we will lose if the trade does not work.   Part of the trade management equation is deciding what must happen in order for us to decide that the trade is not working and that we should exit.   We make this decision before entering the trade - in fact, if we cannot see such an exit point we should not take the trade at all.
We will set stop-loss orders (simply referred to as "stops") at our bail-out points in order to limit our losses.   These are orders sent in advance that our broker will execute if price reaches that point.   The amount of money we are risking is the number of shares traded times the size of that stop.  
Now, as discussed above we want to keep the risk in dollars small and constant.   Remember that the risk is the amount of money that we are willing to lose on a trade before closing it and moving on to another one. (We'll call that amount R from now on.)
Click here to learn how keep the risk the same on every trade.


Sizing the Position


* Ralph Vince has written extensively about risk, risk analysis, and position sizing. We recommend reading any of his works.