Ask any successful trader or investor out there and they will almost certainly tell you that a solid understanding of risk management is the key to their success. In fact, all of them use simple tools for risk management.
What is risk management you ask? For one, it’s predicting the level of risk with any trade and making sure you account for any possible losses. As I’m sure you know, you’re not always going to win every trade, so you’ll need to be prepared so you don’t lose everything.
Here are three things you need to put in your plan that will get you on the right track to help you hone and polish your risk management. Remember to plan your trade and trade your plan.
This is an oldie but a goodie. Do not risk more than one to two percent of your account equity on any given trade or position. Keeping per-trade risk to this amount will help keep you in the game, even during losing streaks. After all, you can’t win the game if you aren’t in the game.
Many traders over trade their account even when they have sufficient capital. Keep your position sizing in check. Only trade more shares or contracts once you have demonstrated consistency and the risk involved falls within your portfolio risk parameters.
While the notion of selling naked options and watching them expire worthless sounds great, nothing can break an account faster than the unlimited risk associated with naked option selling. To keep risk in check, use credit spreads or appropriate hedges. If trading stock or futures, always use a stop. Keep in mind however, that even the use of stops cannot guarantee against larger losses than intended.
These three principles are simply a starting point. Solid risk management is always evolving and you must be willing to adjust to changing market conditions.
Another simple way to look at proper risk management is if a trade or position makes you nervous, you shouldn’t be in it.