If you have any money in the stock market you MUST know this one risk management equation. It has the power to turn even the worst investors profitable and break-even traders into money-making rock stars.
Check it out.
Trading Isn't About Winning and Losing
Most believe that all you have to do to make money in the market is listen to analyst recommendations or breaking news and they'll be set for life.
They couldn't be more wrong!
When it comes investing and trading 95% of people have no clue what they're doing. Investing really isn't about winning and losing.
It's all about the RATIO of how much you make vs. the worst drawdown you can stand.
Cue: risk management.
It's well known in professional circles that anything more than a 10% drawdown in a major hedge fund starts getting clients bitchy...to the point they begin to call up and complain...
- If you're looking for that "home-run" investment, you shouldn't be reading my blog, you should put your money in an Index Fund like the ETF "SPY" and walk. Investing and trading is all about base-hits that compound into a fortune.
What's Wrong With the Popular Way of Risk Management?
My personal threshold for a drawdown is 25%.
But only YOU can answer what your is. Not even a certified "Financial Adviser" can answer that one (which is why I see no use for them in general.)
I'm asked all the time how much of a stock or ETF to buy, which I can't answer.
For starters, it's illegal to give personal advice without a license. And second, I don't know if you're part of the majority that starts losing sleep at 10% or if you've got an ulcer-proof stomach and can take 50%.
You have to use actual REAL money to find out what your personal risk tolerance is (who would have thought).
I guarantee you won't learn a thing by "paper trading."
Here's the popular and lazy approach to risk management. Simply divide your money evenly between six or so positions. I use the example six here because I run six different proven systems simultaneously.
Number of shares = ( account size / 6 ) / stock's price
Example: Number of shares = ( $50,000 / 6 ) / ( $25 ) --> 333
The Way Pros Handle Risk Management
As a quick thought exercise, would you have traded with more or less money in 2008-2009, when the stock market was going bananas?
I hope you said less...
This is something I've seen countless times in my career. People trading & investing with too much money tend to lose it all.
As a professional investor and trader you MUST take into account one extra, but incredibly important piece of information: volatility (how much the stock market is moving around).
You can measure a stock's volatility using average-true-range or "ATR" which can be found for free on most financial news websites (the only thing they are good for, or you can calculate it yourself with a little computer code).
Here's the way pros calculate how many shares to buy at any given point:
Number of shares = ( account size ) / ( stock's price * stock’s ATR * 2.6 )
Notice that with ATR in the denominator, you buy more shares when the market is calm and less when the market is manic (because ATR is low or very high).
Also, note that with your account size in the numerator, you buy more shares as it grows, compounding it rapidly.
A remarkably simple risk management equation, but it's the difference between massive success (the type of money that lasts for generations in your family) and driving your account to zero.
- Use FinViz.com to find the ATR of the stock or ETF you are going to buy and plug it into the equation above
Conclusion: Use the Right Tools and Relax
- You must know the risk you can handle, which only comes from trading with real money in real-time.
- Be a professional and treat your trading like a business.