A risk management plan should be put in place before you enter a trade not after. Have you thought about everything that could happen to the trade before you buy? Would you step off a cliff without looking? Likewise, you should not blindly enter a trade. Prepare your risk management plan before you enter the trade.
Remember it is a lot easier to identify when you will get out of the market before you buy into a position than after your own a stock.
What percentage of your account are you willing to risk per trade?
As a general rule of thumb in the industry, stock traders should risk a maximum of 2% of their account per trade. Many would suggest you risk less.
What does this mean, 2% of your account. It means that if you have a $10,000 trading account, you can only risk $200 per trade (10,000 x 2/100). As an example, if you buy a 100 shares of a $28 stock you would have to sell it if it dropped below $26. However, if you bought 200 shares of the same stock you would sell below $27.
How much can you lose and still sleep at night? Let's look at the table below. It gives a number of different account sizes and 4 levels of risk, 0.5%, 1%, 1.5% and 2%. Thus, if you have a $25,000 account and only wanted to risk 1.5% of your account on each trade, the most you should lose on any one trade would be $375.
Can you sleep at night knowing that you have $2,000 on the line? Would you be a better trader if you only risked $1,000? Only you know the answer.
People generally need time to work their loss acceptance amounts up. For instance, if you are new to trading with a $10,000 account, loosing $200 on one trade may seem like a lot of money to risk. If this is true for you, drop down to the $50 to $100 level until you feel comfortable risking this much per trade. Only increase your level of risk once you become comfortable.
Another risk management strategy talked about by Alexander Elder in “Come Into my Trading Room” is the 6% rule. This rule is meant to protect your overall trading account from major losses. He states that at any one time you should not have more than 6% of your trading account at risk. Basically, if you buy three stocks at 2% risk each, you cannot buy any more stocks until these first 3 stocks move up and you have moved your stops up. This book contains more information on risk management and a brief description of it can be read in our technical analysis book section.
To protect your trading account, you should not go beyond the 2% per trade or the 6% total risk limits.
If you are interested in improving your trading results, take the first step and start to get educated now. Risk management is one of the key areas you need to learn about before you can trade successfully.