From a good trading guru! Thought this would be of interest to the board!
elder.com
RISK CONTROL
In recent weeks I’ve been talking to a friend who hit a wall in his trading and lost a lot of money this year. When I found out about his losses, I asked to see the records for one of his accounts. Two causes of his bad losing streak jumped at me from the spreadsheet he sent. First of all, he kept violating the 2% and the 6% money management rules. Second, he was very lax using stops, and I saw stocks in his account that he bought for 88 trading down at 49 and worse. Let us review his mistakes.
The 2% Rule forces you to limit your risk on any given trade to 2% of your account equity. Of course those of us who trade larger accounts tend risk a lot less than 2%, but this Rule sets the absolute maximum risk level.
For example, if you are trading a $200,000 account, you cannot risk more than $4,000 on any trade. Suppose you buy a stock at $30 and put a stop at $26 – your risk is $4 per share. Now you have to divide your total permitted risk, which is $4,000, by your risk per share, which is $4. $4,000 divided by $4 comes to 1,000 shares – the 2% Rule dictates your maximum position size. In practice, the number should be even lower to cover commissions and possible slippage.
The 6% Rule limits your maximum loss per month to 6% of your account equity. Taking that $200,000 account, if your equity dips to $188,000, you are forced to stop trading for the rest of the month and spend the remaining time re-examining your performance.
The 2% and 6% Rules put a dual safety net under your account. A person who does not have enough discipline to follow these rules is doomed in the markets. Violating these rules is like driving on the wrong side of the road. No matter how good a driver you think you are, one of these days you will have a face-to-face encounter with a cement truck, which is what happened to my friend.
Following the 2% and 6% Rules is a straightforward discipline issue – if you do not have it, you do not belong in the markets. Or perhaps you do – to provide winnings for those of us who follow the rules.
The second major issue in my friend’s drama was not using stops. There are two main types of stops – I call them hard stops and soft stops. A hard stop is an order given to your broker – after buying that stock for $30 place a stop order to sell automatically if it dips to $26. Many professionals do not like using hard stops and prefer soft stops – they have a level in mind at which to bang out of their trade. A soft stop gives them the latitude to cut and run a little sooner or a little later, using their professional judgment.
A beginner trader has no choice but to use hard stops unless he wants to become shark food. Soft stops are very appealing because they give you more freedom. You can earn the right to use them only by proving that you have iron discipline and good judgment. You prove it by having at least one full year of successful trading with hard stops. The appeal of soft stops is that they sometimes allow you to sidestep whipsaws; the danger is that they allow you to delude yourself that your stock is about to reverse while it keeps going against you. My friend who lost all that money is a big fan of soft stops.
I felt very sad looking at his spreadsheet – is another good man going down the drain? After reviewing his records, I explained it was a life-or-death situation for him in terms of trading. To recover he must religiously observe the 2% and 6% Rules, as well as use only hard stops for the next year.
Money management and record keeping, which we will discuss some other time, are the bedrocks of successful trading – just like voting and the jury system are the bedrocks of democracy.
Signatures are so yesterday!
