The Holy Grail

Rick Wright

Hello traders! This week I’d like to discuss a topic that everyone is aware of, but seemingly many new traders don’t take very seriously. That topic is risk management. In every Online Trading Academy class that I teach, I ask the simple question: “What is the Holy Grail in trading?” Numerous answers come up, from supply and demand to trendlines to moving averages to a combination of technical indicators – MACD, Stochastics, etc. In my opinion, these answers are all wrong.

In my experience, the Holy Grail in trading is risk management. Everything else mentioned tells us when or where to trade with their corresponding odds enhancers – many more of which are discussed in our Extended Learning Track rooms. But what happens when the perfect trade comes up? Do you risk your entire account, and your trading account, on this trade? Of course not! This is where one factor in proper risk management comes up.

So how many risk management rules are in your trading plan? Hopefully at least one! The following is a list of suggestions including reasons for them.

The first rule I suggest is how much to risk of your account on a particular trade. A suggested range we instructors recommend is anywhere from 0.5 to 2% of your risk capital per trade. If you have a $10,000 trading account you are trying to make the best investments with, this would be from $50 to $200 per trade. The reasoning for this is if you have a losing streak of several losses in a row, you won’t blow up your account waiting for those winners to arrive.

Our next rule is the number of trades you may have on at a time. If you risk 2% of your account on every trade and have 50 trades on at once, you are risking your entire account! Obviously it would be difficult to have that many trades on at once, from both trade management and buying power perspectives. A suggested number of trades at a time would be from two to four-I’ve found that when I have four or more trades on at the same time, it can be a bit frantic to manage them when the market is moving rapidly!

My third suggested rule is the number of trades you will do in a day, week, or month, depending on your trading style. This was covered in my Lessons From the Pros article dated August 21, 2012, which you can read here.

Another rule you may consider is changing your position size when going with or against the primary trend. This is slightly more subjective, as one active day trader may be watching the 15 minute chart for trend, and a swing trader might be watching the daily chart for their primary trend. The idea is simple: when trading with the trend, use your full position size according to the percent rule mentioned above. When trading against this trend, use half of your available percent risk. If you use the 2% rule for trend trading, then you would use 1% of your account when going against the trend.   The reasoning is fairly straightforward – we don’t expect to have as many winning trades when going against the trend, so we should risk less for when the losses inevitably happen. Why would anyone trade against the primary trend? Occasionally the market has a very strong move in the trend direction, right into a level of supply or demand, giving us a chance to make a few pips on the expected retracement. Yes, this is more aggressive, but many traders like to use this technique.

The next potential rule is a daily or weekly loss limit. If you plan on risking 2% per trade, will you take 20 trades today? If you lose on all of them, your account is now down 40%! Not a good day! A suggestion is 5% per day or week. If you hit this number, you are done trading for the day! Imagine your worst trading day. If you had a limit like this in your trading plan, would that day be as bad as it was? I doubt it.

The last rule we’ll discuss is what I call a trailing stop on your profits. Imagine this: you are having a good day, and are up $1,000 and you keep trading. Your profits wither away to only up $500. Then down to a flat day. Then down to a negative $500! I can tell you that I am not the happiest trader to be around when a good day turns into a losing day! A rule that I have implemented is similar to the following: when up $1,000, I have a trailing stop of 50% on my profits. This means that if at any time my profits deteriorate to only $500, I close my positions and shut down my platform. When my profits get to $1200, the trailing stop is now $600, and so on. Now, don’t activate this rule when you are only up $10! Everyone will be a little bit different, but we want our trades to start to work, and then have a “good” day before turning on this rule.

So there you have it! A few rules that, if added to your trading plan, hopefully will get you closer to the Holy Grail in trading!

Until next time,

Rick Wright

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.