Minimize Losses Every Time

10/18/2011 1:30 pm EST

Focus: STRATEGIES

Courtney Smith

President and CIO, Courtney Smith & Company

Managing risk is a core component of successful trading, and veteran trader Courtney Smith explains some stringent rules designed to ensure that no loss ever deals a big hit to your account.

You’ve all heard of risk management, but what does it really mean? For each trader, it means something a little bit different. 

Our guest today is Courtney Smith. He's going to talk about what it means to him. So, Courtney, first of all, what does risk management mean to you?

Well, the second most important thing for making money in the markets is risk management. Number one is the psychology of trading; number two is risk management; and number three is the actual entry and exit rules that you use. 

Risk management means the control of risk that you have in your portfolio. Risk, of course, is related to reward, so if we can control the risk, eventually we're going to get a winning trade. 

What is actually “controlling the risk?” Is it as simple as setting a stop? 

Setting a stop is a fantastic way. I'm not going to do any trade unless I have a stop loss in there. I need to make sure I have no large losses.

As a trader, I'm going to have a million losses; but I need to make sure that each one of those losses is a very, very small percentage of my portfolio. I need to keep my powder dry so when the big winners come, I can pile onto those things.

We hear a lot about risk/reward ratios. That means something to each person too. Some people want three-to-one or five-to-one. What are your thoughts on that?

I have no risk/reward ratio in mind. Why? Because I limit my losses to less than 1% of my portfolio, so that's a very low risk, and of course, every single one of my trades I think is going to make me a million dollars. 

I don't have a target in mind because I want the market to give me the full profit that it can. 

There's an old saying in the market, and I've been trading for 40 years, that “The market will go further than you can possibly imagine.” 

The big money is made on the big move, so I never want to have a target in my positions, but I do want to control the risk to make sure that if I'm wrong, it doesn't really matter.

You mentioned percentage of your portfolio. When you set stops, is it a set percentage of 0.50% or 1% away, or is it based on something technical?

No, what I do is identify the optimal entry point and the optimal exit point. 

When I talked about 1%, I was talking about 1% of my equity. For example, that could be one contract, it could be 100 shares; it doesn't matter.

People say to me, “Do you trade stocks, futures, options, forex; what do you trade, Courtney?  I say, “I trade my equity statement.” 

When I'm saying 1%, I'm picking the ideal entry point, the ideal exit. I'm dividing that amount of risk per trade into my risk limit, which is 1%, and that tells me how many shares or how many contracts to buy.

And that “ideal” exit or entry, is it based on technical or fundamental levels? What do you use there?

I use fundamental analysis to first of all give me a bias in the marketplace and to change the size of my position.  I use technical analysis to give me that optimal entry and exit position.

And how about scaling in or scaling out? How do you know what kind of size to put on and when to make those big moves?

Well, I do use fundamental analysis, I use seasonal analysis, I use other types of analysis to tell me if I want to deviate from my 1% rule. My default is 1%. 

Let's say, for example, my technicals tell me that it's a bullish trade, but at the same time, my fundamental analysis tells me that it's also bullish. Let's say the seasonals are bullish. I may go up to 2% on that trade.

I use those other factors—which are very poor at timing—to accentuate the trade, or maybe I'll still put the trade on, but it will only be 0.5% if the fundamentals are bearish. I still have to follow my rules that have been proven to make money over the years.

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