As day traders, we are always focused on finding profitable trading opportunities. After all, the point of day trading is to make money. While profitability is clearly the ultimate goal of all trading activities, it’s also important to focus on risk management. Properly managing your risk, or improving your current risk management system, can improve your profitability just as much as sharpening your trading skills.
Think of this concept with a basic example:
Trader A places 10 trades during the day. His gains total $2000 and his losses total $1500 for a net profit of $500.
Trader B places 10 trades during the day. His gains total $1000 and his losses total $500 for a net profit of $500.
Both traders end up making the same amount of profit even though Trader A had higher gains on the day. Let’s say Trader A wants to make $1000 profit the next trading day. Which do you think will be easier: chasing an extra $500 in profits or minimizing losses by $500?
Cutting losses is 100% within your control, whereas increasing profits relies on a stock’s price action and many other factors.
This concept seems obvious, however, it’s easy for traders to get caught up in chasing profits and forget that limiting losses can have the same positive effect on their bottom lines.
So, let’s discuss a few ways to limit losses.
Stock Market Risk Management Strategies
Have a Plan & Control Your Risk
Trading the markets is risky no matter how you approach it. While you cannot completely eliminate this risk, you can limit your exposure to it. Before you enter any trade, you should have a plan that dictates exactly how much you are willing to lose. The goal is to find a solid risk-reward setup. If you enter a trade looking to make $300 in profits, you may decide to cut losses at $100. There’s nothing stopping you from pressing the sell button when you are down $100, therefore, you have control over your risk.
Set a Max Dollar Stop Loss
We’ve talked about max dollar stop losses in another post. These should be used as your ultimate fail-safe when a trade goes against you. It was mentioned above that you should go into a trade with a planned risk. While this strategy can protect you a majority of the time, sometimes a stock will make sharp, unpredictable moves. When this happens, traders can become frantic and uncertain of what to do next. In cases where you can no longer honor your initial plan, you need to have a backup plan. A max dollar stop loss can become a trading rule that will help you in these situations.
For example, let’s say you have a max dollar stop loss of $500. You enter a long trade with a set risk of $200 but the stock drops rapidly on a negative press release. All of a sudden you are down $600 and can no longer stick to your initial risk management plan. What do you do? Cut losses! It’s easy to start rationalizing at moments like this, however this type of rationalization can often lead to much larger losses.
Don’t Trade With Money You Cannot Afford To Lose
This tip is pretty straightforward. You shouldn’t be betting your life savings on on a trade. The market can surprise you at anytime, and the last thing you need is for a trade to put you in a hole you can’t get out of. Obviously, no one likes losing money, but losing money is much worse when you need it to survive. If you’re trading with your rent money, you’re putting yourself in a dangerous position.
Cut Losses Quickly
No one likes to lose, but losing is a part of day trading. You must come to peace with it. Often times it may seem that cutting losses locks you into a losing position. It almost feels like admitting defeat. While it’s natural to want to keep fighting and turn the loss into a win, it’s important to remember that you have zero control of what the market does. Sure, sometimes you can turn a loss into a win, but if you don’t get in the habit of cutting losses early, you are setting yourself up for future devastation.
Be Cautious with Margin
Above, we discussed the fact that you shouldn’t trade with money you cannot afford to lose. Well, you definitely cannot afford to lose someone else’s money, so you need to be extra cautious when using margin. Margin serves it’s purpose, however it needs to be used properly.
Never Leave Positions Unattended
Anything can happen in the stock market. Even veteran day traders are hit with a nasty surprise from time to time. Never leave yourself vulnerable to these surprises by leaving an open position unattended. If you’re in a day trade, you need to be able to watch it. If you have to step away, or if you’re in an overnight trade, make sure to take the necessary precautions (such as setting hard stop losses).
Set Hard Stops to be Extra Cautious
Some traders use hard stops frequently while others prefer to enter their stops manually. There are benefits to both approaches. That being said, if you really want to control your risk, you should set hard stops. This can help protect you from big drops or spikes that can drain your portfolio. While there’s no guarantee that these stops will always get filled, using them adds an extra level of security to your trading plan.
Avoid the Unknown & Stick to Your Niche
Last but not least, it’s important for you to stick to what you are good at. We’ve discussed the importance of finding your niche in another post. This helps you avoid putting yourself in situations where you are out of your area of expertise. For example, if you are primarily a long biased trader and you try to short a volatile runner, you are exposing yourself to unnecessary risk. This would be similar to a basketball player trying to play football. Sure, they are both sports, but the skillset is completely different. Focus on what you do best and you will yield much better results