How To Avoid Getting Killed

Anyone who trades the stock or futures markets, needs a set of money management rules to live by or the market will quickly take all of your money and sanity. Too many times I see people picking decent ideas only to lose over and over due to poor use of money management and other trading strategies to minimize risk.

Here are 4 basic rules that can help anyone who is active in the markets:

1. Before entering any trade, make sure you have an exit plan:

This seems simple but a lot of people don’t or they only have half a plan. By half a plan I mean they have an expected target OR a stop level. You need both. Where would you get out if you are wrong, and where would you get out if you are right? In addition, if you are partly right (goes 1 point up and you thought it should go 3), where does your stop move to, and at what level do you risk nothing – meaning your stop is moved to break even. In addition, you need to be dynamic in your thinking.  What I mean by this is – if you go long at 20, and it SHOULD move up to 20.5 but its sitting there or selling while the market moves up, you need to change your target to get out at a better price.  Odds are when this happens it will eventually stop out.  Your goal when that happens is to minimize loss.  The same goes for market conditions – if major market moving news comes out, DONT just sit there and wait for stops to happen, be proactive.  Worst case scenario you judge the news or the market wrong and get out at the wrong time.  The good thing on trading is you can literally just go back in within seconds if you think you made the wrong decision.  Just don’t forget to make a gameplan when you do that.

2. Assess current market conditions for both long and short:

Watch what the market is doing overall – is it super choppy (lots of erratic up down moves), or is it trending higher or lower. This definitely has a big deal to do with stock selection and risk. If the market is trending higher steadily, shorting most anything carries additional risk as investors and traders are in a buying mood. Most of the time the smart thing is to cut expectations if shorting into an uptrend, or buying into a downtrend. While occasionally you might catch the exact turn, the most likely scenario is you are right for a small amount, then the trend continues and proves you wrong. This is also the spot where people tend to either ignore stops or give something a wide berth when its not warranted because of “gut feel” or using logic like “its way overvalued/undervalued here based on today’s action.” Basically it comes down to trend or counter trend.  When with the market, let it run, when against the market, be quick to cut.

3. Scale your size so that all potential gains and losses are somewhat equal.

This is very important. Based on the volatility of a stock and risk, you should play more shares if less risky, and less shares if more risky. Usually with more risk comes more movement. What you don’t want to happen is you play 500 shares of a stock that can at most move 1 point per day and also play 500 shares of a stock that can move 7 points in a day. If the trade does not work out, the one that can move 7 points kills your account, and its hard to make up. You should scale size assuming every trade will lose. I cannot stress this part enough. Ignore the potential gain, scale the size so the losses, if wrong, will be close to equal. The gains will take care of themselves.

This way you have a decent shot on the next trade to make back the loss on the prior trade if it does not work out. Its kind of hard to make back a 5 point loss if most of the stocks you are trading can only move 50c at a time. Actually its impossible really, as you would have to be 100% right on 10 trades in a row which is a rare feat. This does not mean all shares are the same, it means the risk of loss is the same – if the risk is contained, you can play bigger size – meaning on stock A you play 5k shares with a 15c stop, and stock B you play 500 shares with at 1.25pt stop – if both lose, its about the same amount of loss.

4. Have a goal for the day for stopping trading, both on the upside AND downside.

Do not have unrealistic expectations about how much you can make in a day.  It is easy to let greed take over and think you can make more and more.  Usually, if you are excited about the amount you have banked in (locked in) YOU SHOULD STOP.  As soon as you start concentrating on the P/L, your focus changes, your stock selection changes and a whole host of mental things comes into play.  Basically it becomes very hard to objectively take a trade.  Your assessment of risk is just off.  A general rule of thumb – whatever dollar amount you have in the market on average, you can make at most 1.5% of that in a day.  Most of the time, at 0.75% you will start to have trouble.  This is a rule for short term trading only, and assumes you are not loading into super expensive stocks (100+) which take more capital to trade.  On average, you should never risk more than 1.5x your average gain on a decent day.  If you are down 1x your average gain, you should cut back the size in half.  If you reach 1.5x your average, you should stop for the day.  This keeps you from getting such a big loss you need 5 big days to make it back – simply too hard and puts too much pressure on yourself.

These are by far not the only rules needed, but are some basic ones that most people do not follow. These will not make up for poor trade selection and timing, but can and will help any trader or investor to improve results.