Win More Just by Risking Less
06/20/2012 2:25 pm EST
By considering potential losses ahead of potential profits, traders can ensure they take only the most favorable risk/reward set-ups, thus preserving capital and confidence, says Jeff White.
My guest today is Jeff White, trader and a blogger at TheStockBandit.com. Jeff, a lot of people talk about managing risk, but what does it really mean in the market as a trader? How do you do that?
Well, it’s interesting. The market requires that we take some risk in order to get paid, so everyone understands that there is an element of risk to trading, but you don’t have to be a high-risk trader to do well.
It’s important that you take a survival-first mentality, and then a profit-second mentality.
Your first aim is to size your trades small enough that you’re able to withstand the hit in case you’re wrong.Â That will keep you in the game and allow you to continue taking opportunities as they come, and then look for the profits on the other end.
I think a lot of traders start off looking at a trade and all they want to consider is the upside. “How much can I make in this trade?” It’s really more important to begin with the downside, in case it doesn’t work out. Can they handle that trade? Can they maintain a level head throughout the progression of that trade and continue making good decisions?
Everybody talks about setting your stop losses and sticking to them with discipline. Certainly, that’s one part of it, but is there more to managing risk than just setting a stop?
I think there is. As a trader, you need to come into every trade understanding where your exits should be.
Personally, I’m a technical trader, so I want to know on the chart where the trend will have failed. Where will this pattern have failed? I need to know what area or what level on the chart I need to be out of this trade.
More importantly, I also need to be sizing my trades small enough along the way that I’m able to continue making good choices. I need to know how much loss I can handle, and it’s not how much I want to lose, but how much can I withstand and still get up and make the next trade?
A lot of traders talk about wanting to risk only a certain amount of their total account. What do you advise people who ask you about how much cash to be risking on any one trade?
I think it’s wise to have a max loss number, and that number may fluctuate from time to time, based on how good you’re trading. It might be 1% of your account; it might be half a percent of your account, and it will differ from each trader based on their comfort level.
Going into each trade, however, that’s going to allow you to size your trade appropriately. It also adds a huge element of protection, in terms of your confidence. A lot of traders, when they enter a trade, know that they’ve got to protect their capital, but a lot of people forget, or fail to protect their confidence along the way.
I’ve known a number of traders who have run out of confidence before they’ve run out of capital, so it’s very important to be cognizant of that as a trader so that you can continue to take the good trades as they come along even if you hit a tough patch.
You’re sizing your positions small enough, and the losses you’re withstanding—while they’re not fun—they’re small enough that you can continue moving forward. I think that’s the whole idea.
So if I have three or four trades in a row that haven’t gone my way, I need to be able to get into that fourth or fifth trade, because that may be the one that makes up the difference?
Absolutely. In fact, a good risk/reward ratio is going to allow you to have multiple losses and one gain that can really wipe out the smaller losses.
I think the aim is not in terms of pointing for more accuracy in your trading, but really to consider trading in such a way that you’re making more when you’re right than you’re losing when you’re wrong.