There is nothing certain in the world of trading. That cannot be changed, but the way that we deal with it differs from person to person. I may roll with the punches when it comes to taking risks, while another person may sit and worry about every move they make. Let’s just take a moment and think about the type of person we are. Are we easy-going risk takers or fearful traders who are more comfortable playing it safe?
We all want to feel some level of protection. However, while some of us know that success does require some level of risk and we put ourselves out there, there are those of us who do whatever we can to avoid risk. Sometimes, we need to fool ourselves into believing that we are protected even if the reality is that we are not. Most of us have heard of a product called “The Club”. Its that heavy metal bar that you lock onto your steering wheel to keep a car from being stolen. Except, it really doesn’t keep our car safe. It’s all an illusion that we build in our mind to make ourselves feel better and while we are living in that made up world, someone is easily cutting through that bar with a hacksaw and driving off in our car. That being said, there are psychological benefits to believing in these types of things, even if the protection is not a sure thing.
When it comes to trading, risk control can take the edge off of the anxiety we may be experiencing. If we put just a small percentage of our capital on a trade, it is easier to tolerate the risk because there isn’t a lot at stake. We may even start wondering why we are bothering making the trade, but this is about limiting risk. There isn’t a hard and fast rule about how much risk to take, but I’ve heard experts suggest anywhere from 2% of our capital to 5% . There are other experts that tell us to use past market performance to dictate who much loss we can afford. For instance, a bullish market will allow for more risk.
The most effective way to manage risk is to set a protective stop. However, whether we choose to set a stop and if we do, how we do it, will be determined by our personality type and how we approach risk. Those of us who are comfortable with taking risks may choose not to set up a stop loss. Perhaps we will have a point at which we stop somewhere in the back of our mind, but nothing written in stone. On the other hand, we may be the trader who is fearful and worried about taking risks. If we are this type of trader, we could wind up setting the stop loss at a price close to the entry price and bow out prematurely. Most of us will avoid either extreme and take a middle of the road approach, but that is contingent upon our personality.
Generally, it can help to have a stop loss if we are fearful of taking a loss. If we are in that category of traders, not having a stop loss could lead to us not closing out a position when the price drops significantly. We may be susceptible to holding on to the hope that things will correct themselves when in fact, we continue to lose when we haven’t acted. Alternatively, if we choose to set a stop loss, we will be out of the trade should the price plummet. What seems to work best is to be flexible when setting a stop loss. Rigidity is something we need to avoid. When it comes to the fearful trader, we should be alert to the fact that we may be fooling ourselves into thinking we are safe when we are not, just like when we put “The Club” on our steering wheel.
Let’s look at an example to illustrate my point. Imagine that we are a trader who has a $100,000 account and we decide that we do not want to lose more than 2% or $2,000 on a single trade. Now imagine that we buy 1000 shares at $50 a share. That means that we have set ourselves up for a potential loss of $50,000. If we are one of those inflexible type traders, we may come to the conclusion that the price cannot fall below $48 and set a protective stop there so that our losses are limited to approximately $2,000. The problem is, this is basically irrational thinking and we have a good chance of being stopped out. Over time, the stock price may vacillate between $47 and $51 as it increases in value over time. We may need to buy less than 1,000 shares and set the stop loss lower so that the risk is kept down to approximately $2,000, or just risk more than $2,000 if the potential profit warrants taking a slightly greater risk.
My point is, the market will always be unpredictable and full of uncertainty. This is a fact all traders need to accept if we are to make rational rather than decisions based upon superstitious beliefs. None of us, no matter where we are in our careers enjoy taking losses. We all want to take comfort in feeling safe, however, taking some risks are necessary. When we begin to accept that fact, we will find that we have a more productive and profitable experience with trading and in life.