Risk management is the science (and sometimes the art) of limiting the losses your account may suffer. One important aspect of risk management is having the proper share size in any trade. You may have an excellent entry and stop loss, but if you are in a trade with too much size, then you have still violated the rules of risk management. But how do you define share size in a trade?
There is a 3-step process that is recommended for traders when they are trying to determine their share size.
Step 1:
Determine your maximum dollar risk for the trade you’re planning. Many traders use a maximum acceptable loss of between 0.25% to 2% of their account depending on if they are aggressive risk takers or conservatively cautious traders. Whatever you do though, you should never risk more than 2% of your account in any single trade. You should calculate this amount before your trading day starts. I recommend 0.5% to 1%, and I suggest, especially at the beginning of your trading career, that you be conservative in protecting your account. If you have a $20,000 account (with $80,000 buying power), your maximum loss on any trade should be 1% of $20,000, or $200. You do not want to lose more than $200 in any trade. That is Step 1.
Step 2:
Estimate your maximum risk per share, the strategy stop loss, in dollars or cents, from your entry. This comes from both the strategies set out in Chapter 6 and an understanding of the risk/reward analysis that I just discussed in this chapter. For each trade that you make, you need to define a stop loss level and a risk value. For example, if you enter a short trade at $14 and put a stop loss at $14.10, Step 2 will be 10 cents per share. Similarly, if you go long on a stock at $100.50, and put a stop loss at the break of $100, your risk is 50 cents per share.
Step 3:
Now divide “Step 1” by “Step 2” to find the absolute maximum number of shares you are allowed to trade each time.
To better illustrate this, let’s return to Figure 7.7, the example of MOH from a few pages back. If you have a $40,000 account, the 2% rule will limit your risk on any trade to $800. This does not include any buying power (the margin) you might have been granted by your broker. For example, you may have a buying power of 4 times your account (in this case a buying power of $160,000), but you must always calculate the 2% or 1% rule based on the actual cash you have in your account (which is $40,000). Let’s assume you want to be conservative and risk only 1% of that account, or $400. That will be Step 1.
As you monitor MOH, you see a situation develop where a VWAP Strategy may very well work in your favor. You decide to sell short the stock at $50, and you want to cover them at $48.80, with a stop loss at $50.40. You will be risking $0.40 per share. That will be Step 2 of risk control.
For Step 3, calculate your share size by dividing “Step 1” by “Step 2” to find the maximum size you may trade. In this example, you will be allowed to buy a maximum of 1,000 shares ($400 divided by $0.40/share).
In this case, you may not have enough cash or buying power to buy 1,000 shares of MOH at $50 (because you have only $40,000 in your account). So, instead, you will buy 800 shares or, perhaps, just 500 shares. Remember, you can always risk less, but you are not allowed to risk more than 2% of your account under any circumstance. Why? Because with every single trade you make, you should always ensure that at least 98% of your account is protected, or in this example, 99%, because you want to be conservative and risk only 1% of your account, or $400.
With the strategies introduced in Chapter 6, I explained where my stop loss would be based on technical analysis and my trade plan. I cannot consider maximum loss for your account because I of course don’t know your account size. You need to make that judgment for yourself. For example, when your stop would be above of a moving average, you need to calculate and see if that stop would be bigger than your maximum account size or not. If the break of moving average will yield a $600 loss, and you have set a $400 maximum loss per trade, then you should either take fewer shares in that trade or not take that trade at all and wait for another opportunity.
You may correctly argue that it will be difficult to calculate share size or stop loss based on a maximum loss on your account while you are preparing to jump into a trade. You will need to make a decision fast or else you will lose the opportunity. I understand that calculating your stop loss and maximum loss in your account size in a live trade is difficult. But day trading is not supposed to be easy. Trading needs practice and I strongly recommend that new traders paper trade under supervision for at least three months in a live simulated account. It sounds crazy at the beginning, but you will quickly learn how to manage your account and your risk per trade. You will be amazed at how rapidly the human brain can do calculations on what share size to take and where to set the stop loss.
Dr. Alexander Elder in his book, Trading for a Living, introduces the 6% rule for risk management. The 6% rule is designed as a guideline regarding how much of your account you're allowed to lose in any given month. According to this rule, you're not allowed to lose more than 6% of your account in a month. If you are down more than 6% in the calendar month, you should switch to your simulator for the rest of the month in order to practice more. The 6% rule prohibits you from trading live for the rest of the month when the total of your losses for the current month and the risks in open trades reach 6% of your account equity.
The purpose of the 2% rule is to protect you from a bad loss on a trade, one that might seriously damage or even wipe out your account and permanently force you out of the world of day trading. Dr. Elder compares the 2% rule to a swimmer who loses an arm or a leg to one bite of a shark. It’s a very tragic loss, and it’s all at once. Dr. Elder argues that the 6% rule, on the other hand (no pun intended!), is to protect you from a series of small losses such as would be inflicted through the bites of hundreds of piranhas. Piranhas are of course known for their sharp teeth and powerful jaws. Although smaller than a human hand, they are extremely predatory and often attack in groups. When former American President Theodore Roosevelt visited Brazil in 1913, he went on a hunting expedition through the Amazon rainforest and, as he later recounted in his book, “Through the Brazilian Wilderness”, he witnessed a cow entering into the Amazon River and then being quickly torn apart and skeletonized by a shoal of hungry piranhas.
Traders can avoid sharks with the 2% rule, but they still need protection from those piranhas. That is why my colleagues and I define the 6% rule: to save traders from being shredded to death. Literally! Most traders, when they are in trouble, will start pushing harder and take bigger risks, trying to trade their way out of a hole, which is a classic definition of revenge trading. A better response to a series of losses is to step aside, go back to your simulator, and evaluate the situation. The 6% rule sets a limit on the maximum monthly drawdown in your account. It’s quite simple. If you reach it, you stop trading for the rest of the month. The 6% rule forces you to get out of the water before even more piranhas reach you.
We all go through periods when every trade we make turns into a loss. There are days when our trading strategies become out of sync with the market, resulting in one loss after another. These dark times happen and traders, especially new traders, must remember not to push themselves. Professionals on a losing streak will take a break and trade in a simulator to resynchronize with the market. Amateurs are more likely to keep pushing until their accounts become crippled. This is the story of Robert, one of my brightest traders. After an astonishing result in his simulator, he went live and did very well in the first few weeks. He was on top of the world until everything fell apart. Here’s his story, in his own words, as posted on our www.BearBullTraders.com Forum.
“Robert wrote: This is embarrassing. I was doing so well alternating between real and simulator this whole week. These were my results:
“Total: 10 green trade out of total of 12 trades: nice profits, and feeling on top of the world!
“And today it all fell apart in spectacular fashion. I traded like a maniac and finished with a huge loss. It was all a blur, but this is my recollection of the events in question:
“After two small losses 10 minutes after the open, I was a bit shook. Then on my 3rd trade, I made a hotkey mistake and doubled up my position rather than exiting. That ended in a huge loss. Shortly after that, I made another hotkey mistake and took another big hit. I was a psychological mess. Rather than walking away, I went on a rampage. I started trading stocks not in play (JD, BABA, MU), and was reckless and vengeful. I said to myself 'f*ck it let's go!' (literally out loud) and fired away at my hotkeys like there was no tomorrow. By 10:30 AM EST, I was 0 for 7. By noon, I had made 13 trades. When it was all said and done, I had made 20 trades total (not tickets, but trades). Only 2 of them turned out to be winners. Talk about lack of self-control...
“I violated every single rule that I had been following religiously all week. I stopped caring about those A1 setups and took anything that looked marginally good. And since SPY was a roller coaster today, I got destroyed by questionable entries and make-belief strategies. I kept trading the same stocks over and over, even after admitting they were not in play. I was trading like it was going out of style. I thought I could outsmart the market and get back at it. It wasn't even about the money anymore. The losses were a foregone conclusion and had evaporated to currency heaven.
“The sad part about this whole tirade was that I knew I was breaking the rules while violating them--and I didn't give a damn about it. In the moment, I turned into the Incredible Hulk and everything switched to auto-pilot mode. I smashed at my keyboard like a savage. Everything I had learned up to this point in my (short-lived) trading career was thrown out the window. I had literally unleashed an animal that I had no control of. I've never experienced such poor self-discipline in my normal life--ever.
“Today was a reminder of how fragile the trading mindset can be. All it takes is one moment--a FILG one--to send you spiraling out of control. All these rules and checklists I had been adhering to were useless in the face of such madness. They were nothing but delicate paper walls I had erected to trick myself into believing that my emotions were in check. They came crumbling down under the slightest pressure. It was all an illusion; I was delusional.
“I have a lot of reflecting and contemplating to do this weekend. I might take a break from trading to rebuild my psyche. Maybe I'll visit a monastery to cleanse myself of all these trading sins. But first I need to forgive myself. Now I'm just rambling like a fool.
“Thanks for reading, and remember--don't trade like a crackhead.
“/rant”
A member of our community responded to his post:
“Welcome to the emotional rollercoaster of trading Robert! According to Mr. Spock, the fictional character of Star Trek: “In critical moments, men sometimes see exactly what they wish to see”. You want to make the losses back, and you will see it in any trade you look at.”
Just like having an emergency plan in place in the case of a fire or an earthquake, traders also need a plan in place to quickly respond to emotional outbursts and trading disasters. I know it is easier said than done, but with time and discipline, you can master it. You really can! Take a walk or go for a run to help clear your mind. The market will always be there. You can come back to it. And, of course, you must accept that some things are simply well beyond your control.
Dr. Elder states that to succeed in trading, you need both confidence and caution: having only one is dangerous. If you’re confident but not cautious, you’ll be arrogant, and that’s a deadly trait for traders. If you are cautious but have no confidence, you will not be able to pull the trigger.
New traders should start small. First you get good, then you get fast! Don't worry too much about the commissions. I know they are eating away your small profits, but as a new trader you are not at the stage yet where your focus should be on making money. Just try to properly execute the right trades and follow the process. I can't emphasize enough how irrelevant the actual results of trades or your profit and loss are at the beginning. Commissions are simply part of the tuition you have to pay for this career. Try to focus on managing your emotions and your feelings, because somehow you truly do have to find a way to manage the inevitable losing streaks.
Reduce your share size when your account is dropping. If you experience a series of losses, your account will obviously be dropping, and you need to reduce your share size. That is the complete opposite of how gamblers think. Gamblers often increase their bets when they're in a losing streak. This comes from the mistaken belief that if something happens more frequently than normal during one period of time, it must happen less frequently in the future. It is very common among roulette players in casinos to bet $10 on one color (either black or red), and if they lose, they bet $20 on the same color, because they think now the odds are in their favor. If they lose again, they bet $40, and so on and so forth, with the hope that the more they lose on black, the higher the chances that black will win. They’re quite simply wrong.
Statistically speaking, when you make a trade and lose, it does not mean that the probability that your next trade will be a winner is higher. Each trade is independent from the others, and all that is really increasing is your level of stress and psychological pressure. The most famous example of this gambler’s fallacy occurred in a game of roulette at the Monte Carlo Casino in Monaco on August 18, 1913, when the ball fell in black 26 times in a row. This was an extremely uncommon occurrence, with a probability of around 1 in 136.8 million. Gamblers lost millions of Monégasque francs betting against black, reasoning incorrectly that the losing streak was increasing the chance of hitting red with the next spin.
There are a number of schools of thought regarding gambling and day trading. Some people believe they are quite similar and some people believe they are very different. I personally fall into the latter side of the question. Let’s use blackjack as an example. I’ve read it’s one of the most widely played games in casinos around the world. In blackjack, there is no emotion for you or the dealer. The rules are set by the number of cards, and their value is fixed, and at most casinos the dealer must hit themself on what’s called a “soft 17”. You have no control over the game. In trading, the more trades that you take, the more emotional you become.
It is extremely important for new traders to ignore time-based profit targets at the beginning. You should not set a daily or weekly goal such as making $200 a day or $1,000 a week. Why? Because if you do, and you cannot get close to your target, you’ll start taking trades that you shouldn’t, or you’ll start increasing your share size with the hope of meeting your profit goal. These types of moves should be avoided at all times and in all circumstances. First you get good, then you get fast!
I had a trader email me once to advise that he was pausing trading after only a few weeks of going live. As I had suggested, he was initially taking trades with only small size. He informed me that he was indeed making money in most of his trades, but he was still in the negative because of all of the commissions and fees he was paying. He then decided to increase his share size too much and too early and that’s when his problems started. I cannot emphasize enough to you how unimportant the results are from your first six months of trading. They do not matter. During these first months, you are building the foundation for a lifetime career. Do you think in year ten that your results in your first six months will be significant?
While there is no one right way to make money trading, there is only one right way to begin your trading career. When you first begin, you must focus on the process of trading, not on how to make money for a living. You must allow at least eight to twelve months before you will become consistently profitable. If you are not willing or are unable to do this, then you should find another career. Some are not able to either financially or psychologically commit this much time to this pursuit. If this is the case, then again, you should find another profession.