With the beginning of a new year many traders will have made revisions to or created their trading plans that they will be using for the coming year. Far too often novice traders fail to write a trading plan and, unfortunately, become a statistic in the trading industry. They will place trades using emotions and not a planned approach to trading the markets.
Another problem novice traders have is the illusion that all their trading plan needs is technical analysis of how to trade. For example, they draw a diagram of a chart with rules on where they will buy and sell. Well, that is a necessary part of trading but not the most important part; most important is writing rules on risk management. For without risk management, you will fail as a trader. I cannot guarantee you many things in trading, but I can guarantee you that if you fail to write rules on risk management you will not be a consistently successful trader.
Risk management has several components to it. In this article I would like to address setting a daily stop loss for your trading.
All traders will have losing days no matter how well you trade or how much experience you have. As a matter of fact, many professional traders still have losing weeks, months and, yes, even years. I was reading recently where Paul Tudor Jones, one of the largest hedge fund managers in the Futures industry, had a couple of losing years after he had been trading for many years and managing millions of dollars. Was it because he forgot how to trade? I doubt it. He was having problems getting in sync with the markets from other issues in his life. If a trader with this much experience and money can have losing years and still come back and be a winner, he must know something about risk management.
What if he kept trading and turned into a revenge trader after losing hundreds of thousands of dollars belonging to his clients? Would his clients continue to give him money when he started trading well again?
As traders it is natural that we do not want to have losing days, weeks, months or years. The difference between the professional and the novice is, the professional knows when to stop trading and seek help. The novice trader with no risk management rules will continue to trade out of control. Soon they will turn into a revenge trader and then the inevitable happens – they blow up their trading account.
The title of this article explains what happens to a trader who blows up their trading account. They have to get a job to raise capital to trade again. Risk management allows us to have capital to trade with once the proverbial light bulb comes on in our heads and we learn how to trade. Imagine how frustrating it would be to now have the knowledge, but you do not have the trading capital.
Day traders would do well to have a maximum loss per trading day in their written trading plans. The reason we need to write this number down is because it is too easy to ignore it if we just have a number in our heads to stop trading at.
Most traders use a rule that each trade will risk 1-3% of their trading account. This will allow a trader to have a series of small losses and still be able to trade tomorrow. The problem seems to be when to stop trading for the day?
One way of finding this maximum loss amount is to say that if you lose 3% of your trading account in one day you must stop trading for that day. Or, perhaps you could say that if you have 3 losing trades in a row you must stop trading for that day. The goal is to have a loss amount that tells you to stop trading for the day.
It will be painful to stop trading because we all want our money back. But something is not working on this particular trading day for you and your account is telling you to stop. If you think it will be painful to lose 3% of your account, just imagine if you lose your self-control and your revenge trading costs you 30-40% of your trading account in one day?
Another way to find your maximum loss for the day can be found if you have been trading for a few months. Take the last month of trading and add up all of your positive trading days then divide that amount by the number of profitable days you had. This will give you an average daily profit you have made over the last month.
Let’s say your average daily profit on your winning days last month was $435. You can use this amount as your maximum daily loss. The reason is that you know on average you have been making this much money on your winning days. So, if you have a losing day it should only take you one day to make back your losses.
Whichever formula you use the most important thing is to have a maximum dollar loss for every day you trade. Without it you may be hanging out a window asking, “Do you want fries with that?,” trying to make some money to allow you to trade again.
“Whenever you find yourself on the side of the majority, it is time to pause and reflect” Mark Twain.
– Don Dawson