Risk Management in Stock Trading: 3 Things You Need to Know

Risk management in stock trading is essential for preventing excessive losses and protecting your profits. Unfortunately some traders never learned how important it is — and lose it all. In this short blog, we’ll point out three things you need to know related to risk management.

Here’s one wise gem from the Limitless Volume Day Trading course worth writing a hundred times on the chalkboard:

“Amateur traders are rigid in their expectations and flexible in their rules. Professional traders are rigid in their rules and flexible in their expectations.”

Those two sentences sum up the three key things you need to know when it comes to risk management.

1. Have A Trading Plan and A Daily Trading Routine

Before getting into any trading, successful traders create a trading plan with rules that protect them on both the upside and the downside – and then they diligently follow that plan! 

Coming up with a set of rules you can truly rely on doesn’t happen overnight but requires reviewing your trades and studying past trading setups.  (We recommend a form of “journaling” your trades as a means of evaluating your trading plan and its application.)

So, one important aspect of this trading plan is establishing your daily trading routine.  This involves preparing yourself before, during and after the trading day to align with your trading goals.  (While this is a more extensive subject than we can cover in this article, we’ll give a few pointers here.)

In a way, trading is like a competitive sport.  It may sound crass, but to obtain a profit someone else must lose.  You’re competing against other traders in the market.  While many may not be as serious about trading as you are, there are many who are really “doing their homework” so they can get ahead of those who are not.

Your pre-market routine should involve maybe 30-40 minutes before the market opens where you are laying out your approach to the trading day.  What are market conditions looking like?  What stocks are in play or on the “watchlist”? Are there any important economic events happening today? Are there any news headlines from overnight?  Knowing these things helps protect you from unnecessary risk and loss, such as getting blindsided by quick volatile market movements.

Your intraday routine should be focused on not much more than your own charts. You should have alerts in place (such as from the CNBC app) to inform you of any significant happenings in the market, but you should be particularly focused on your own charts.  The first couple hours after the market opens is when the best swings happen and the best time to be active as a day trader. Look for patterns to form that will tell you when it’s time to make a move on your watchlist stocks and be looking for a good entry point.

Finally, your post-market routine is critical to the success of your trading plan, and you MUST NOT skip it. This is where you’re objectively reviewing your trades without the emotion you experience while you’re trading.  We HIGHLY recommend a “journaling” approach which we teach in our Day Trading course and follow-up training.  This involves keeping records of past performance (and reviewing them without bias) gives you a basis for what needs to be improved upon. 

2. Calculate Risk, Stop Losses and Control Profit Taking

     One key risk management aspect of the trading plan is setting stops to prevent extensive losses.  For beginners, we recommend setting a “stop loss” exit point on a trade that doesn’t risk more than 1.5% – 3% of your total account size.  Yes, that’s a small amount and means you will see smaller returns and your account will grow more slowly because you won’t be able to take the bigger trades, but as a beginner it’s important that you gain confidence without blowing up your account.  An experienced trader with a larger account may extend this to 10% or even 20% of the account size.

However, it’s important to remember there is no set rule here. The key is finding that balance between a stop that isn’t too tight and isn’t too large.  There’s no way around it — to do this requires experience. Learn how to do this precisely in our Limitless Volume Training Course!

Remember: “Professional traders are rigid in their rules and relaxed in their expectations.”

Regardless of the level of risk you are comfortable assuming, it’s vital that your stop loss point be respected each and every time!  Be rigid in keeping to your rules. 

Don’t convince yourself that you should just let the trade roll past your stop point in hopes that things will turn around.  Instead, be flexible in your expectations.  Accept the loss and move on.  Then, use your daily post-trading time to “journal” your trade and evaluate it in the context of your past trades.  When you have enough history to work from, then you can adjust your plan if you see a pattern of error in your approach.  Are you trusting your stops?  Are you waiting too long to enter a promising trade?  To see these patterns you need to get enough history under your belt without blowing your account in the process — hence why you need to set conservative stop loss points until you’re 100% confident.

Another key part of your trading plan involves knowing when to take profits.  Missing the opportunity to take profit is just as bad as rolling through a stop-loss point in hopes the stock will turn around (and getting killed by it). 

Here are a few general guidelines to protect your profit:

• Close-out your position if you’ve given back more than 30% of the day’s earnings.
• If your position is not small, apply what we call the “50% rule” to capture a run on the price.  Once the stock price reaches your target, you can hedge your earning potential and take some profit by closing out 50% of your position.  Then set your new stop point at 50% of the previous candle and let the remaining 50% of your position ride while you keep moving the stop up to 50% of the previous candle as they form.  This way, at the very worst, you capture a profit even if the stock reverses course.
• However, if your position is small, don’t be looking to capture a run.  Instead, take your profits fairly quickly if you’re up a nice amount in the stock.  The idea is to grow your account as quickly as possible so you can size-up on your trades.

3. Consider Your Position Size

Calculating your position size has a direct relationship to the level of risk you allow yourself to assume in a trade, but also involves other factors such as the conditions surrounding your trade.

After considering your max risk, some factors to consider when sizing your position in a trade are:

• Time of Day and Volume – Market volume varies drastically throughout the trading day.
  • The best trading opportunities typically present themselves in the first couple hours after the market opens – this is when you want to use your max position size if other conditions look favorable.
  • During mid-day, volume drops significantly, so if you do see opportunities during this time, we recommend using just a third of your max position size.  However, probably the second-best time to trade is between 12:45pm and 1:45pm (the “1 O’Clock Pop”) when the big boys get back from lunch and volume picks back up. 
  • Finally, the third-best time to trade is in the last hour of the day but be careful – during this time there are often “fake out” trades which quickly shoot in one direction only to reverse to the other, so only trade when you see “A-level” opportunities! It’s during the last half hour of the trading day that the large hedge funds release large numbers of shares and rebalance their portfolios, so you’ll see crazy movement up or down.
• Market Events – When the market is waiting for some specific news, big players have no problem sitting out and waiting for it.  While day traders want lots of volume to fuel the direction of their trades, volume will be low at those times when the big players are on the sidelines, so downsize your position.  “Big news” occasions like this include FOMC Meetings, FOMC Minutes, and “Triple Witching” days.
• Positive vs. Negative Profit / Loss 
  • When you’re profitable for the day, protect your profits: (a) take additional trades at one third the normal position size, (b) don’t give back more than 30% of the day’s earnings, and if you drop below this, close out all positions and be done for the day, and (c) downsize your position if it has the risk of giving back more than 30% of the day’s earnings.
  • When you’re trading with a loss, (a) don’t size-up by taking another trade with a position twice as large to try making-up for the loss, and (b) avoid “revenge trading” where you force a trade to recover from a previous loss but take time to think before jumping into a trade after a loss.

The Bottom Line

Risk management in stock trading is essential to mitigate losses and to protect profits.  It all starts with seeing a good trading opportunity.  But once you have a solid trading plan, you’ve set your max risk, and you’ve determined the right position size for your trade, you can execute your trade without fear and set yourself up for future success when you stick to your plan. 

Experience is the best teacher, and the best teachers have vast experience.  Fast-track your way to success with a master day trader as your mentor – join us as a Limitless Volume trader!