Rule Number 1: Never lose money. Rule Number 2: Never forget Rule Number 1.
Unfortunately, losing money as a trader is inevitable. It’s part of the game. Some trades will simply go against you.
The key is to be well prepared so that you can minimize those losses when they do occur.
Every loss requires a greater gain to recover from. And, as those losses increase, the gains just to get back to even increase as well.
If you have $100 and you suffer a 20% loss, you now need a 25% gain to earn that back. A 50% loss is going to take a 100% gain to recover and on it goes.
If you suffer a 100% (or more) loss, well, you’re done for. It’s what Taleb calls the “absorbing barrier” or “blowing up.”
It takes money to make money — as the old adage goes — and that’s even more the case in investing.
This is why risk management is so important to an investing strategy.
Sizing, Signaling and Re-balancing
If you’re a value investor like Buffett, you primarily rely on price as your risk management strategy. The cheaper you’re able to buy something the greater the margin of safety you have.
If you’re an algorithmic or technical trader, then there are a few different tools at your disposal:
- Exit signals
- Position sizing
- Position management
Far too many retail traders ignore these at their peril. They put too much into a position and don’t have an adequate strategy in place to get out. Soon enough, they blow up.
You’ve been warned, so don’t come crying to me because you took on too much risk!
Let’s look at each of these more closely.
Exit Signals
The trusty stop loss is the bread and butter of traders looking to control their risk. The idea is that as soon as the price of your security moves below your loss, you sell. Typically, this will cap your loss at that level.
So, if you put a stop in at 10% below your entry price, you expect that you’ll lose a maximum of 10% on that trade. In extreme cases (like market crashes) you can blow through your stop loss and lose more, however this is rather rare.
There are a myriad of ways to set your stop loss. You can set it as a fixed price (like the 10% example above), you can use volatility measures like ATR or standard deviation to set it.
There are heaps of ways to go about it. The key is to define a rule and stick to it.
There are some systems that trade without a stop loss. Instead, they look for an exit signal — often a trend reversal.
Be careful though because not every trading system can work without a stop loss which can lead to large and irrecoverable losses.
Position Sizing
How much do you put into a trade when you open it?
If you have $100, does it all go into the trade or do you put a little bit into it? Or do you leverage that and put in $150?
A common mistake among new traders is to put everything into a position (I love Bitcoin, but too many people I know have put everything they have into it).
If your 100% committed trade doesn’t work for you, then you’re screwed. It can be worse if you applied leverage.
Like your exit strategy, you can size positions in a near infinite number of ways.
Traders often start with a fixed 2% of their portfolio per bet. There are better techniques, but this is a much better way to control your risk than 99% of retail traders out there.
And for the love of God, don’t use a Martingale strategy.
Position Management
Once you have properly sized a position and placed your stop loss, you can manage your position to further control your risk.
A common technique is known as volatility targeting. This works by adjusting your position size based on its volatility. As volatility increases, you might take some money off the table. If it decreases, then so has your risk, so you can add to your position to go for a higher reward.
Other methods may add or subtract from your position as certain risk levels or targets are hit over time, or may simply rebalance your portfolio as positions shift relative to one another.
Trade with Protection in Mind
Whatever your chosen method, it’s important to backtest it thoroughly, then stick to it as you trade.
We’re always adding new methods and ways to manage your portfolio so you can be profitable over the long run and avoid the permanent loss of capital that plagues so many everyday investors.
Check out our free demo here!