Simpler Risk Management

You may think of yourself as a trader. Or you may fancy becoming a trader. But what you really want to become is a risk manager. That is arguably the most important job of any trader.

There are many facets to risk management. And that is one of the reasons that I highly recommend keeping a trading journal. The first page of your trading journal should include your trading rules.

You must have rules about when and what you buy. That must include position sizing. Many traders bet too large. For beginner traders, the maximum size of your risk in a position should be 1-2 percent of your trading capital.

That takes us up to the more important issue of when you sell. The most important rule you have is when to sell when you have a loss. With equities that may be an 8 or 10 percent loss from your entry. You may use stops, but you must remember that using stops are not absolute, overnight gaps can lead to bigger losses, so that should be considered. I have had people tell me they will risk 20-25 percent of their account on one position. If that is the case, then with four losses in a row – possible with the best of strategies – you are done.

This takes us into a discussion about using options instead of stop losses. With a stop loss you may look to limit your losses to 2 percent, or 10 percent of the purchase price, but the loss could be much greater than that. With options, you know exactly how much you are at risk of losing.

You also need rules about when to get out for gains. This is more art than science. But some traders will take off some of their position at given price points. Some will use trailing stops.

As you get into more advanced trading, you need further rules. If you are using spreads, you can consider closing out parts of the trade at certain set points as opposed to the whole trade. This is especially the case with credit spreads as you can end up with cheap “lottery tickets” at essentially no cost if things work out right.

Option sellers of all sorts should have rules about when to buy back positions they have sold, as at a certain point the risk is no long worth holding the position.

All of this should be clearly written down in your trading rules. Those rules should be reviewed regularly, and for beginner traders that is likely every morning. And then you just have to follow them….

Chris McKhann

Chris McKhann

Chris McKhann has been involved professionally with the stock market for more than 15 years and specifically with derivatives for 12 of those. He started as a stock broker, but quickly moved on to options and futures trading. He spent some time as the Derivatives Product Manager for TD Ameritrade. He was the chief analyst and hedging strategist for OptionMonster. He has been an options trading educator and content provider for many years. His writing and analysis has been featured on Reuters, the Wall Street Journal, Forbes, TheStreet, CNBC and internationally. He has also designed and traded option and futures strategies for prop trading firms and hedge funds as well as managed accounts.

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