Trading is easy, right? It certainly looks like that to the uninitiated. After all, it’s simply a case of choosing a stock, predict whether it will go up or down, put your money on and then wait to take your money out once the predicted movement has occurred.
Only if wealth creation was so simple and risk free but obviously it isn’t. Indeed, if it were then everyone would be doing it. But obviously, it’s not as simplistic since markets don’t move in totally predictable ways. Stocks have their own unique life, and movements within the bigger world of economics influence at the micro and macro level.
In a bull market things are far more predictable and there is less risk of things suddenly shifting against you but in the more recent markets, especially during earnings season where things are less predictable or can change significantly in a very short space of time, it is harder to make profits consistently.
Gone are the days of the dot-com and pre GFC housing bubble era with big returns. Now it is essential that anyone entering into the trading world be aware of the risks and gives the market the respect it deserve when planning and executing trades.
There are three parts to trading that need to all be managed in order to do well and mentally survive. These are financial resources, trading strategy and psychological preparation. Of these the financial resources are the most self evident as it refers to the capital you have available as a whole and then the amount that you are prepared to risk on any one trade.
In general, 0.5-1% is a standard amount to choose until you are an experienced/expert trader. Then decide what strategy you are going to follow, of which there are many but not all fit the current market conditions as well as your personality.
One that is a possible consideration is value investing, buying stocks where prices have been pushed below intrinsic value due to fear and volatility. Another is momentum swing trading where a financially strong stock has declined in the short term significantly and traders are coming back and buying heavy volume and pushing prices back up.
Once you have your strategy, you will need to work out your level of risk you are going to take, how much capital you are going to put at risk on any given trade.
This is where trading shows how much of a numbers game it is. Whilst choosing 0.5-1% of capital as your trade amount, it is also essential to recognise that there can be large range in price for some stocks. Then on top of this you need to decide how many trades you are going to make since if you execute ten trades, that actually means you have a total exposure of up to 10% of your capital at that moment. Is that a risk you can afford to take emotionally and psychologically and are you able to sit there and cope with all of them potentially turning a loss?
Managing to cope with the stress of watching ten trades with so much overall capital on the line can be extremely stressful. The stress can blind you to the markets and thus increase your risk as you find yourself unable to focus, think clearly or potentially react if the markets shift. So what do you do?
The obvious answer is to reduce the risk and the stress by only executing a few trades or even lowering the position size percentage. What is essential is to not feel that this means that you will never be able to achieve bigger profit taking in the future or that you need to turn over lots of high risk trades in order to be successful as the numbers game works in your favour again here.
Building up your capital step by step will make you successful and slowly but surely you will be able to risk greater amounts whilst sticking to your 0.5-1% risk strategy. This way you gain confidence and become better able to cope with the stress of having an exposure of over 10% of your capital.
It is evident that you need to have all three parts of the process in place in order to be able to trade with success and with a better ability to cope. Strategies become defunct as markets change and risk management means that if all your chosen trades fail, it is within manageable means both emotionally and financially.
Also, when learning the trading game you are clearly going to be short on experience and insights and therefore you need risk management even more as you have to presume to lose more than you win. Giving risk the respect it deserves will eventually lead you to the fruits of your experience and enable you to potentially become one of those traders who turns big profits from the markets.
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