To do proper risk management when trading stocks comes close about how to enter and exit, which is you need a consistent approach to managing your risk. Risk comes in a couple of different forms. There is the risk that you might be wrong on this trade, wherein you buy, but it goes down, this is called a stock-specific risk. There’s also catastrophic stock-specific risk, wherein the risk is when you buy a stock, and it doesn’t just go down, but it collapses, the company goes bust, and you lose everything.
That’s a much lower chance of happening but a much higher dollar impact. Therefore, there’s average stock-specific risk and catastrophic stock-specific risk, there’s also a disastrous market risk, where I’m invested in stocks and the market crashes, and my whole portfolio goes down with it. Therefore, there are three levels of risk that you want to think about when you’re managing your risk in trading.
Hence, how do we manage it across those three levels of risk? The first thing we got to do if we think about stock-specific risk if we’re wrong on this trade is we want to make sure that we lose a tiny proportion of our total trading capital because you could be wrong and will be wrong many times in a row. If you’re right 50% of the time and you’re wrong 50% of the time, it’s like if you flip a coin, and if you flip a coin, the chance of getting a losing streak of five or ten trades long, is a reasonable chance of getting a five or ten coin flip losing streak.
If you’re trading, the chances are similar, you can also get a long losing streak of trades. Thus, you’ve got to make sure that when you’re wrong, you only lose a minimal amount so that your capital doesn’t get completely eroded by a string of losses, then you manage your stock-specific risk by putting only a small proportion of your account at risk on each trade. How small? Less than 1%.
Therefore, if you’re wrong on the trade, you should lose less than 1% of your account on that trade. It doesn’t mean you take 1% of your account and put it into that stock. Let’s say to make the numbers easy, you have a $10,000 account, 1% of that $10,000 is $100, you don’t take $100 and invest $100 in each stock. If you buy a certain amount of stock and it goes down a little bit, so you have a stop-loss that gets you out. Let’s say the stop-loss gets you out, you buy at $10 a share, and the stop-loss is at $9 a share. Therefore, if you have a $10,000 account, you’re risking 1% of the account on each trade, and if you’re wrong, you only want to lose a hundred bucks. If you buy at $10 a share, and your stop-loss is at $9 a share, that’s $1 per share that you will lose on that trade if you’re wrong.
You can afford to lose $100 because that’s the 1%, so you can only buy a hundred shares of that stock. Because that way, if you buy it at $10 a share, and it goes down to $9 a share where your stop-loss is, you’ll lose your $100, the 1% of your account, and it’s not going to be so much that it hurts you.
Accordingly, that’s how you manage stock-specific risk, wherein you keep the losses on each trade very small. However, it will be hard to risk such a small amount when you’re beginning, and you’ve got a small account, so you might have to start with 1% or 2%. Then, as your account grows, you want to risk even less, wherein most of my systems risk about half a percent of my account or less per trade. That way, it doesn’t matter if you have a losing trade, you get out, and move on to the next one—no big deal.
Catastrophic stock-specific risk is this slight chance that something extreme could go wrong. Let’s say you’ve got a $10,000 account, and you get a really hot tip from an inside source that this company is going to the moon, and you’ve put your whole $10,000 in the account. However, it turns out that that company was a fraud, and it gets de-listed and goes to zero. How much of your account have you lost? All of it. Therefore, we have to think about the minimal chance of losing the entire investment in that stock.
The way you manage that is not by avoiding the market altogether; it’s by making sure that the size of your trades, the dollar value, is not that big, and if you’re wrong and it hits your stop-loss, you might lose 1%. However, you want to make sure that the total dollars invested per stock are less than, 5% or 10% of your account.
Therefore, if there’s a catastrophic loss, once in a thousand trades, it doesn’t wipe you out, or it doesn’t even hurt you so much that you have to lose sleep over it. Although it’s annoying, but it doesn’t kill you, which is good, therefore, that’s a catastrophic stock-specific risk.
You also got market risk, this is if you think about your whole portfolio. If there’s a dislocation in the market, how do I manage that? Let’s say you’ve got a $10,000 account and use a lot of leverage. This is back to the Forex issue of why so many Forex traders blow up. Let’s say, you’ve got a $10,000 account, you take on a lot of leverage, and you buy $50,000 worth of stocks. You can do that depending on which broker you’re using, then the market collapses 20% overnight because a war breaks out, a new pandemic, a dirty bomb goes off in New York, etc.
Market collapses 20% overnight, and you can’t get out, if you are leveraged that much, you walk away with nothing but debt. You owe your broker a fortune, and to manage such catastrophic market risk, you’ve got to make sure your total exposure is such that if the market collapses 20% overnight, which is possible, because that’s happened before. If the market collapses 20% overnight, you can live to trade another day.
Therefore, three levels of risk management will keep you in the game, and by staying in the game and having a profitable system over time, you build wealth, and you don’t get wiped out. Thus, that’s how you manage risk when you’re trading stocks.