Making money in the market is easy. Even trained monkeys with darts can find winning stocks. The challenge is not giving those profits back in the next losing trade.
Losses are inevitable. Anyone who believes they can achieve a 100% win-rate is not realistic and coming to the market with unhealthy expectations. Losses to a trader are like inventory for a retailer. They are simply a cost of doing business. As long as revenues exceed expenses, the business is profitable and everyone is happy.
There are two ways to make money in the market. One is taking small profits from a large number of trades. This is how market makers, high frequency traders, and option sellers make their living. The challenges in this business model are avoiding big losses that wipe out all the small profits. The other strategy is capturing huge profits from just a few trades and breaking even or taking a small loss on everything else. These are the black swan traders betting on the next big crash, or high-growth speculators targeting the next big thing.
The small profit trader typically has a laser focus in one area of specialization. The market maker specializes in just a few securities or stocks. High frequency traders find a niche and exploit certain pricing phenomena. Option sellers focus on one stock, index, or strategy. Each of these specialists has the knowledge and experience necessary to avoid taking a big loss and can comfortably concentrate his entire portfolio in a single area, idea, or strategy. This is the proverbial doing one thing and doing it well.
The big-hit strategy is on the other end of the spectrum and makes a lot of small bets in the hope that a few will pay off huge. Rather specialize, this approach requires diversification. The rate of success is abysmal and successful traders often lose money more than 60% of the time. But they can sustain these high failure rates because the losses are small and the winners huge. Since the big-hit trader doesn’t know which one will work, he has to try lots of different things.
But no matter what approach a trader uses, money management techniques are similar. A good rule of thumb is never risk more than 3%-5% of your total account value in a single trade. The reason for this is quite simple, it is easy to recover from a 3%-5% loss. Even a series of them. In fact it would take 24 consecutive losing trades to cut your account value in half. While losses are normal and expected, 24 losses in a row is an extraordinary stretch and highly unlikely. But even following a historically improbable string of bad luck, the trader still has 50% of their account balance remaining. The key isn’t avoiding losses, but ensuring we live to fight another day.
Now I will clarify what I mean when I say never risk more than 3%-5% of your account value in a single trade. This doesn’t mean everyone should use 3%-5% stop-losses on all of their trades. Several examples are the easiest way to explain this concept.
Bob has a $100k trading account. He has his portfolio diversified across five different trades in equal amounts of $20k each. Bob tends to be conservative and uses the 3% loss limit in this trading. Losing 3% of this $100k account value equates to $3k. When applied to each $20k investment, that $3k loss means he can afford to take a 15% loss on an individual trade without doing serious damage to his account.
(A word of warning, diversified means dissimilar trades. Five airline stocks or five 3D printing stocks is clearly not diversified since a failure in one trade likely means a failure in all five.)
For an index trader, if his entire account value is in a single trade, then he can only afford to lose 3% to 5% on that single trade before he should be pulling the plug.
Another way to use the 3% to 5% loss limit is to help you size your trade. Let’s say John is an aggressive options trader also with a $100k account. John is willing to risk 5% of his account value on a single trade, which comes out to $5k. His strategy uses a stop-loss if the option value falls to 50% of what he paid. That means his position size should not be more than $10k. If John is willing to let his premium go all the way to zero, he should not put more than $5k into any single trading idea.
Losses are an inevitable part of trading. But it will never be a problem if you manage your money properly and ensure you always live to fight another day.
Of course the above assumes a worst case loss. Successful traders learn to recognize their mistakes long before a stop-loss is reached. I will cover closing a losing trade proactively in another CMU post. Sign up for Free Email Alerts so you don’t miss it.
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Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.