One of important thing in trading is how to control risk. As I’m new to trade, there’s many knowledge need to learn.
How to control risk
An intelligent scuba diver always keeps an eye on his air tank’s pressure gauge to make sure he has enough to return to the surface, with a safety margin. The money in your trading account is your air supply. Watch it, be economical in its use, and have a reserve.
All beginners, no matter how bright, make mistakes and take losses. Be sure to keep your losses small, don’t let them threaten your survival.
The most important rule of risk control is THE TWO PERCENT RULE: never risk more than 2% of your account equity on any given trade.
Begin by writing down three numbers for every trade: your entry, target and stop. Without them a trade turns into a gamble – and you’re not here to gamble, are you?
Later, in the chapters on technical analysis, we’ll discuss how to set these three numbers. At this point, simply recognize that every trade requires a stop and that the distance from your entry to that stop determines how many dollars you’ll risk per share.
Let’s say you plan to buy a stock at $30 and expect it to rally to $35 – that is your target. As a cautious person and not a gambler, you decide to place a protective stop at $28 – the level you
set through technical analysis, to be discussed later. Buying at $30 and protecting at $28 means you’ll be risking $2 per share in this trade.
Next question: how much money do you have in your trading account? Let’s say you have
$20,000. What is 2% of $20,000? It is $400 – and that’s the maximum amount you’re allowed risk on any trade.
Next question: how many shares of that stock may you buy? Well, if your maximum permitted risk is $400 and your risk per share is $2, you may buy up to 200 shares. You may buy fewer shares but you may not go above the number given to you by the 2% Rule.
The maximum number of shares you may buy is determined by your risk per share and your total permitted risk.
The Iron Triangle of Risk Control: “A” is the maximum risk for your account (2% of its current value); “B” is your risk per share (the distance from your entry to your stop); “C” = A divided by B.
You don’t have to risk 2% of your account on every trade – you’re perfectly welcome to risk less, but you may never risk more. The bigger your account, the lower percentage you want to
THE SIX PERCENT RULE states that you must stop trading for the rest of the month whenever your losses reach 6% of your account equity at the beginning of that month.
If and when losses start piling up, take that as a sign that your method isn’t working in the current market environment. It’s time to pause and step aside for a while. Once your drawdown hits 6%, that’s the end of trading for the current month – no new trades.
This is similar to placing a stop on a trade – the 6% Rule places a stop on your account, limiting the maximum damage that can be caused by a series of losing trades. The 6% Rule breaks losing streaks, giving you time to think and regroup.
Most traders get killed by fish – either a shark bite (a single disastrous loss) or piranha bites (a series of losses, none of them lethal, but together they shred an account to the bone). The 2%
Rule will protect you from the sharks. The 6% Rule will save you from the piranhas.
You may never increase those limits, but feel free to lower them, especially the 2% maximum loss per trade.
If you use the 2% and 6% rules, a series of only three losing trades can knock you out of the game early in the month. If you reduce your maximum risk per trade to 1%, you’ll double the number of trades you may take before being forced to step aside.
Lowering your risk per trade to 1% or less will give you more latitude to practice your tactics.
Before we close this chapter, a quick comment on account size. A tiny account makes it very hard to diversify, while large accounts tend to lull beginners into a false sense of security. At the time of this writing, I’d say that the sweet spot for beginners is somewhere in the $20,000 to $50,000 range.
It is big enough to diversify but small enough not to get carried away. Remember that an intelligent beginner trades to learn. Imagine going to a dental or an
engineering school: you wouldn’t expect to make a living out of it in your first year of schooling.
Focus on learning and acquiring skills, become a survival expert. Trade small and keep good records. If you do it right from the start, you’ll be making good money later – instead of overtrading, getting hurt near the starting line, and becoming demoralized.
Risk management will make you a safer trader. In the next chapter we’ll discuss good recordkeeping, a key tool for your growth as a trader.
Source :- Stock Charts