Managing Risk

Hey Gang:

After the BIG FALL back in late February, I thought I'd touch upon my FAVORITE trading topic: managing risk.

I am not at all ashamed to say that last year (my first full year of trading), I managed risk really poorly. Because of that, I got hammered in many plays I should not have. Sure, there were emotional ties to my trades, and I subjected myself to some "pride of ownership" issues (if I own it, it MUST be good) and for my sins, I lost a lot of money.

But I learned A LOT! Yes, the lessons were painful, humbling and downright nasty at times, but the end result was I completely changed my trading philosophy, and it paid off BIG TIME during that 400+ point meltdown recently. I really have to give my thanks to "Come Into My Trading Room" and my 3 Day Live classes in Salt Lake City for cementing the importance of Risk Management. In fact, I don't really trade anymore. I manage Risk.

What is it, and how do I do it?

Risk, in this case, is the exposure my portfolio has to the dangers of the market. The more exposure I have, the more risk (also known as "portfolio heat") I have. Having a lot of risk exposure is foolhardy at best, and downright stupid at worst. High Risk = High Stress, if things are going badly, your stress level increases exponentially, and trading under duress is a recipe for disaster. So avoid it at all costs. The nice thing about this, is that is it simple to manage risk and trade in control.

We all have worked hard for our money, and that last thing any of us wants is to take years of that labor and lose it on a surpise correction, or a piece of bad news that kills a position. Now NEWS is the great equalizer, it can destroy a great trade, or reverse a bad stock, or boost a good play to a great one. You want to protect yourself from the bad news, the good news will take care of itself.

To protect myself, and to minimize stress levels, I have hard and fast rules with my portfolios. They are rules that now are NEVER BROKEN. Here they are:

The RULES are the RULES because they are the RULES

1. After the end of the last trading day in a calendar month, calculate the opening value of each portfolio by using the closing price of all equities, as well as the cash balance. This is my OPENING EQUITY AMOUNT.
2. Calculate the current risk exposure in equities by using the closing price minus the Stop-Loss price.
3. The MAXIMUM risk for any one trade is ONE PERCENT (1%) of the portfolio value. (Example - $25,000 portfolio = $250 MAXIMUM TRADE RISK on any one trade)
   
4. The MAXIMUM risk exposure during the month for any portfolio is SIX PERCENT (6%). (Example - $25,000 portfolio = $1,500 MAXIMUM PORTFOLIO RISK)
   
5. Position sizing must be rounded DOWN.
   
6. Once a maximum of risk exposure of 6% is reached, you must STOP TRADING until such a point as an "At-Risk" trade moves to where the Stop-Loss price is increased to where if taken out, the play will be PROFITABLE. (I use Trailing Stops)
   
7. If a trade is stopped out for a loss, that trade must remain in the risk management calculation until the following month.
8. If the portfolio loses 6%, ALL TRADES (the profitable ones and non-profitable ones) must be closed, and I must wait until the following month to resume trading. This is a COOLING DOWN PERIOD (to prevent "Get Even-itis).

You can make up your own rules, but these seem to work for me.

Happy Trading!