Understanding Risk and Reward
One of the most important aspects, and in my opinion, THE MOST IMPORTANT aspect of trading is understanding risk. If you have been following this blog for any length of time, you know that I mention and talk about the risk-reward ratio in everyone of my positions that I take on. With every transaction, whether it is a day-trade or a swing-trade, I use a stop-loss without fail - in fact, I cannot recall the last time I failed to use one. Stop-losses are what keeps me in the game, yeah, they absolutely suck at times, because when you use them, it isn't uncommon to see a position that you have on, go against you, trigger the stop-loss than soar on to new highs. But if I were to add up all of the times that has happened, and the amount of money it cost me, then add up all the times it has saved me from complete portfolio ruin - there is no comparison between the two. In essence, using stop-losses is equivalent to having an insurance policy for your portfolio - it costs money, no one likes using them, but they are absolutely necessary!
What I use to manage risk, and determine my position size is a Risk-to-Reward spreadsheet that I created to determine my position sizes. First I determine what my Risk or "R" will be (i.e. the dollar amount that I am willing to lose on a single trade). Then I buy the number of shares up to the amount that will not allow me to lose more than my pre-determined "R" value. On the flip side of the coin, I want my gains to be in multiples of "R" (i.e. 2R, 3R, 4R, etc.) and our losses to be kept consistently at 1R or less (preferably less!).Once I have determined what R is, and the number of shares that I can buy/short without risking more than "1R", I place my order and once the it has been executed I enter my stop-loss (usually as a "first-triggers-all" condition with the original order - don't worry if you are not familiar with that term).
As a matter of note, the tighter the stop-loss the greater the potential to realize multiple R's on my trades. I am not so much interested in the percentage gain of the stock itself as I am interested in the "R" multiple on my trade. If my stop-loss is only 0.25% of the share price and I am willing to risk 0.5% of my portfolio on the trade, then I am able to realize 4R or a 2% increase in my portfolio value if the stock goes up only 1%. Whereas if my stop-loss is much wider at 1% of the share price and I am willing to risk 0.5% of our portfolio on the trade, then I would need to see the share price increase by 4% in order to realize the same return on the value of my portfolio (while I still realize a 4R on this trade it required that the stock appreciate by 4% versus the 1% in the previous example). So in my day trades I seek to find setups with relatively tight stop-losses (within reason!) so that I may buy more shares to trade with, which will lead to my trade returns being far greater. Just remember, the key is not so much the percentage of what the stock goes up, instead it only matters what the R multiple is on the returns - that is what determines my profits and my return on my capital. As you can see, I can achieve returns of 2R, 3R and even 4R or more on trades that only move a few percentage points, based on where the stop-loss is. Not Bad At All!
I'll be posting more on this topic as it is SO IMPORTANT to your trading success, even at the expense of being redundant.
If you want the same spreadsheet that I use, you can download it on my site.