Three-Step Risk Management
Step 1: Determine your maximum dollar risk for the trade you’re planning (never more than 2% of your account). Calculate this before your trading day starts.
Step 2: Estimate your maximum risk per share, the stop loss, in dollars, from your entry. I will explain later
in this book what the stop loss should be depending upon which specific strategy you are planning to trade.
Step 3: Divide “1” by “2” to find the absolute maximum number of shares you are allowed to trade each time.
To better illustrate this, let’s return to 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. 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 the VWAP Strategy (see Chapter 7) may very well work in your favor. You decide to sell short the stock at $50, and you want to cover them at $48.82, 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.
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, even 500 shares. Remember, you can always risk less, but you are not allowed to risk more than 2% of your account under any circumstance.
With the strategies introduced in the pages to come, I explain 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 a moving average (see Chapter 5 for information on the indicators on my chart), you need to calculate and see if that stop would be bigger than your maximum account size or not. If 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 waiting 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. Remember Rule 2? 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.