I wrote about trading, and in particular about gearing via the use of derivatives, as well as what we should (or shouldn’t) be trading in a previous article (that you can read here). I promised to return to the other two parts of the equation: How to employ a stop-loss and how to manage risk.
Let’s start with stop-losses, because without this a trader will go bust. It’s as simple as that.
But, firstly, it is important to note that I am referring to trading and not to long-term investing. A long-term investor has a stop-loss, but it is a different beast based more on fundamentals rather than pure price.
For a trader a stop-loss is simply a pre-determined price at which they will accept that the trade is going wrong and then exit. This is done to preserve capital. It is very important that the stop-loss level is decided before the trade is entered into and that it is rigidly adhered to.
The only time you’d move a stop-loss is when you are moving it in your favour. When the share price moves up, you adjust the stop-loss upwards. But when the price turns downwards, you leave your stop-loss intact.
The really hard part is determining where to place the stop-loss. I typically use a ‘dumb’ stop-loss; one that is a certain percentage away from entry. You can also decide to be fancier and check chart levels before deciding the best price at which to put the stop-loss. One could even use technical analysis such as a MACD (moving average convergence divergence) cross or the like, albeit a technical stop-loss will usually be fairly wide.
On the point of a wide stop-loss: Ensure that you give your trade time to mature and move. I often see equity traders place stop-losses of between 1% and 2%. But a small dip in the price and they’re out – only to see the trade then surge in their direction… without them.
Afterwards, they blame the concept of stop-losses, whereas the placement was in fact the culprit. I’ll say it again: Without a rigid stop-loss process and execution, you will go bust. Every time. Sure, it’s hard, but it is critical.
The second point is risk management. This element includes the use of a stop-loss, but it also includes position size. In other words, how big should the trade be?
What I usually see here is trades that are far too large for the capital being used. For example, a R10 000 account risking a R3 500 stop-loss in a single trade. Three losses in a row (which is very likely, especially for a beginner) and it’s game over. All your capital is gone.
Here one needs to use the 2% rule. This rule states that you should only risk 2% of capital in any one trade. The R10 000 portfolio can risk 2% or R200 in a single trade. With trading costs added, it simply means that proper risk controls cannot be used.
Sure, that means smaller trades, but it also means that a short string of losses won’t wipe you out. Using the 2% rule, it’ll take almost 50 losing trades before you will go bust. Importantly, smaller trades are easier emotionally as the money involved is not inducing stress.
The next step in the process is then to know your 2% amount as per above. Determine your stop-loss, say 800c. Then if entry is at 900c, you have 100c risk per share/contract for difference (CFD) and you divide that into the 2% value to determine how many shares or CFDs to enter into.
What the astute reader would have spotted by now, is that the 2%-rule means a small amount of capital. And that means you can’t enter into proper risk. Correct. You need a decent amount to start. The cheapest place to start is the mini Alsi (Almi) with a minimum investment of R10 000. Shares or CFDs need a minimum of R50 000 (double this amount is better), while forex requires at least $5 000.
A final point. Trading is easy but, like any other skill, it needs to be learned and that process will take years. Risk management helps to ensure that those years don’t cost you a fortune.