Most stock trading advice revolves around how to use technical indicators to make reasonable bets on the direction of a stock. But the truth is that lack of technical analysis ability is not the main reason that stock traders lose money.
Most stock traders regularly have winning trades. But they lose money because they make less money on their winning trades than they lose on their losing trades.
So how can you avoid this common mistake?
Three prices to determine a winning trade.
If you want to have a winning trade, the first thing you have to do is to determine three prices: the entry point, the take-profit point, and the stop-loss point.
Always set these points ahead of time, at least in your own mind. Don't set them in the spur of the moment, when emotions are running high.
Calculating position size.
Once you've got these three prices, the next step in risk management is to calculate the correct position size. Follow these steps to do that:
- Subtract your stop-loss from your entry-point. This is the amount of money you're risking per share.
- Multiply your account size by the percentage of risk you are willing to take. For example, if you're only willing to risk 1% of your account on a single trade, then multiply your account size by 0.01. This is the amount of money you have available to risk on one trade.
- Take the number you got from step 2 and divide it by the number from step 1. This will tell you how many shares you're allowed to buy based on your risk preferences.
Here's an example:
In the chart above, the entry-point is 232.5. And the stop-loss is 231. So let's say that you're willing to risk 3% of your account on one trade (most pro stock-traders risk 1-5% per trade). And let's say that you have $10,000 in your account.
$232.5 - $231 = $1.50. This is the risk per share. And $10,000 X 0.03 = $300. This is the total amount you're allowed to risk. So the number of shares you're allowed to buy for this trade is $300/$1.50 = 200 shares.
Note: Because the stock in this example has a high share price, there is not enough money in the account to buy 200 shares. So you'd have to use leverage to maximize your gains. But many other stocks do not pose this problem.
Risk Management: Calculating Reward Vs. Risk
Once you've got the position size figured out, you can calculate the reward/risk ratio using the following steps.
1) Subtract the entry-point from the take-profit point. This is the potential profit per share.
2) Multiply the potential profit per share by the position size. This is the potential profit for the trade.
3) Multiply the position size by the risk per share. This is the total amount you could lose if the trade goes against you.
4) Divide the number from step 2 by the number from step 4 to get the left side of the reward/risk ratio. The right side is 1.
In the example above, potential profit per share is $237.00 - $232.50 = $4.50/share. Potential profit for the trade is $4.50/share X 200 shares = $900. The total amount you could lose is $1.50 X 200 = $300. So the reward/risk ratio is 3:1
Generally, any trade with a 2:1 or greater reward/risk ratio is a good trade. Anything with less than that is usually not good, unless you are using a trading strategy with an abnormally high win percentage.
Don't make less money on your winning trades than you lose on your losing trades. Follow these risk managementprinciples and turn a profit over the long-run.