Complete Approach to Risk Management

03/12/2012 1:30 pm EST

Focus: TRADING

Dave Whitmore

Senior Strategist, Trading Education, E*Trade Financial

Risk management is much more than just placing stops, explains E*TRADE’s Dave Whitmore, who reviews a well-rounded approach to managing risk that starts before the trade is even placed.

As a trader, you probably hear a lot about controlling your risk and risk management. Our guest today is Dave Whitmore to talk about risk management and what that means. So Dave, first of all, let’s define what risk management really is.

Well, we try to think of it at E*TRADE as having a variety of facets starting with pre-trade planning, which is one of the most important aspects. 

For instance, using charts to understand where a stop-loss point might be and where a reasonable target price is; having an exit strategy; knowing where you’ll get out; knowing how you’ll get in. 

The second step is to understand what vehicle you’re going to employ for that trade. Are you using margin?  Are you using options? Are you using leveraged ETFs? All of these introduce a whole additional layer of risks. 

So putting it all together, it means having a strategy, knowing how you’re going to enter a trade, why you’re going to enter a trade, and having an exit plan including a stop point.

And then there are a variety of tools that can affect that: conditional orders for example, stop orders, and trailing stops. A wide variety of tools that many individual investors aren’t totally familiar with, and we try to teach those techniques.

One of the things I hear a lot about is that you should always limit your risk on any one trade to a certain percentage of your account. Is there a recommended percentage?

Well, there are a lot of theories on this. For instance, Jim Cramer says to own five stocks and put 20% into each one. Investor’s Business Daily says to take an 8% stop and get out at that point.

The point is that most traders—and many successful traders—feel that they’re only going to have winners 50% or 60% of the time. They know they’re going to be wrong half the time, and it’s keeping those losses small and letting your profits run that makes successful returns for your trading.

All right, so maybe we should talk about a specific way that we can look at a chart maybe and find a place on there that would match our risk tolerance. Is there a way to combine technical analysis and my risk?

Yeah, it’s a technique that we discuss at length. The first thing to understand is when you look at a trade position, understand where support is and at what point would you deem that stock to have broken down.  Whether that’s the moving average that’s providing support, or a trend line that’s providing support, or even where an oversold condition might come in on an oscillator of some sort. 

These are points where you have to understand what is the percentage of your capital that would be lost, and then does that trade make sense for what the chart tells you could be a reasonable profit point. 

Making that small calculation and understanding the volatility that is bound to be there is part of that pre-trade planning, and we try to have our customers and traders understand how to plot and create a strategy.

You mention volatility, so I should probably choose a market that is within my risk tolerance and is not so volatile that I’m going to constantly get stopped out because I have to put the stop too close; in other words, to match my risk.

One of the topics that we teach is understanding what Beta means, and when it comes to things like exchange traded funds, understanding the standard deviation, which is sort of the numerical expression of that volatility. 

Once you know that number, now you’ve got an understanding of how much value is at risk at any given point. 

We have to understand there’s randomness to stock price movements. All we’re doing with technical analysis is getting probability on our side and believing that we’ve tilted the field in our favor, but we still have to understand that randomness can crop up at any time, and it’s making those calculations based upon chart formations that is a big part of playing technical analysis and a pre-trade strategy.

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