Editor's note: We're taking a break from our usual fare in today's Weekend Edition with an essay from our colleagues, Ben Morris and Drew McConnell of DailyWealth Trader. In this piece, originally published in October 2018, Ben and Drew guide readers through the process of planning and executing trades successfully – in any market environment...
To become a rich, successful investor, you must always focus on how you can lose money. You must always focus on risk.
Once you've taken care of the risk, you can move on to the fun stuff – making money.
The thing is, amateur investors are always 100% about making money... the upside of a trade. They're always thinking about the big gains they'll make from the next big tech stock or from their uncle's new restaurant business.
Amateur investors don't give much thought to how much they could lose if things don't work out as planned... if the best-case scenario doesn't play out.
And the best-case scenario usually doesn't play out. Since the novice investor never plans for this situation, he gets killed.
That's why you should always plan for the worst in the markets. This essay will help you understand how to reduce your risk in a worst-case scenario...
Planning every trade and trading the plan will make you a vastly better trader.
When it comes to risk, your plan should have three steps...
- The first part of your plan should be defining your exit strategy... like using a stop loss.
A stop loss is the price at which you'll exit the trade. It defines the size of your risk in the trade.
There are different types of stop losses... You might use a "hard" stop, which is simply a particular share price. Or you might use a trailing stop, which moves higher as the share price moves higher.
- Once you decide what type of stop loss to use, the next step is to decide how much risk is appropriate for your portfolio.
This amount should be small enough that it will be easy to recover from. And it should be small enough that if you do lose money, it won't keep you up at night. We recommend you limit your risk to no more than 1% of your portfolio.
- After you choose your stop loss and decide on the amount of capital you're willing to risk, you're ready to calculate your position size for each investment...
Let's say you've set a 15% "hard" stop on a trade. And you're willing to risk losing 1% of your portfolio.
Now divide the percentage of your portfolio at risk by your stop-loss percentage. This will give you your position size:
Capital at risk / Stop loss = Position size
If you put 6.7% of your portfolio into the trade and use a 15% stop, the most you can lose is 1% of your portfolio.
Let's walk through these steps with an example...
Imagine you have a $100,000 investment portfolio and you want to figure out how many shares to buy of a fictional company we'll call "Acme Corporation." Shares are trading at $20.
First, you decide you'll use a 15% hard stop on the trade... So you'll sell Acme if shares fall to $17.
Next, you decide how much of your portfolio to risk on the trade. You might think about this as a dollar amount or as a percentage. Let's say in a worst-case scenario, you don't want to lose any more than $600, or 0.6% of your investment portfolio.
Now you can calculate your position size and the number of Acme shares you should buy...
0.6% (Capital at risk) / 15% (Stop loss) = 4% (Position size)
Or you can use the dollar amount...
$600 (Capital at risk) / 15% (Stop loss) = $4,000 (Position size)
Then just divide your position size ($4,000) by the share price ($20) to figure out how many shares to buy... $4,000 / $20 = 200 shares.
It's important to keep in mind that your trading results won't be exact.
You may not be able to close a trade right at a 15% loss... It may end up being 18%, or possibly 25%. That's because the markets are volatile... And some stocks are more volatile than others.
The more volatile a stock, the more likely it is to "blow through" your stop. That's why we generally recommend smaller position sizes with volatile stocks.
That's all there is to it. If you plan your trades and take care of the downside... the upside will take care of itself.
Ben Morris and Drew McConnell
Editor's note: With the help of one system, more than 3,000 Stansberry Research subscribers were warned – with 100% accuracy – that this year's historic market crash was imminent. Some wrote to us saying they saved hundreds of thousands of dollars. And on Thursday, May 28, we're sharing how they did it. Mark your calendars... You don't want to miss this event. Click here to sign up now.