Risk Management Is Key to Day-Trading; Most Traders Consider the Most Important Aspect of Day-Trading Last of All: Risk Management. These Simple Guidelines Will Help You Embrace Risk Management and Survive to Trade Another Day
Busby, Thomas L., Modern Trader
If you want to know something about the fallout from poor risk management, consider this personal account.
In 1987, I lost everything.
On Oct. 19, 1987, my life was rosy. I was a vice president of a major brokerage firm. The family was doing great. I had a nice house, cars and other amenities that a cushy income could provide. By the time I crawled back under the covers that same evening, however, I was broke. The Dow Jones Industrial Average had plummeted more than 500 points, losing approximately 22% of its total value. Across the board in the United States and around the world, the financial markets took a nosedive. My portfolio crashed with them.
I was heavily invested in options. On Thursday, Oct. 15, 1987, I was long 1,000 S & P 100 puts, but I was also short 1,000 S & P 100 puts. I had some protection because the short position offset the long one. The offsetting positions were supposed to be my insurance against calamity.
However, all of that changed on the following day, Friday, Oct. 16 when my long positions expired. The short positions still had a month to go. That left me with naked options; in other words, they had no cover. I had sold 1,000 puts that I did not own and I had guaranteed a buyer that I would deliver if the strike price was hit.
On Black Monday, the strike price was hit and I had to produce. I was forced to buy them at a high market price, even though the market was dropping like a ton of bricks. If I had been able to hold my long puts for one more week, I would have made millions of dollars, but in October 1987, the market did not wait for me. I was a couple of days late and a thousand puts short.
It took me years to recover from the crash of 1987. I suffered a huge financial loss, but I endured an even greater psychological one. I lost faith in the markets, and I lost faith in myself. Over many months and several years, I worked to understand the mistakes I had made and to formulate a trading strategy that minimized risk. Today, I am a much different trader than I was before Wall Street taught me that hard lesson. I respect risk.
If you respect and manage risk, the rewards will come. Risk management is the skill that separates the winners from the losers. Everybody makes losing trades. Those who manage their risk cut losses quickly and preserve capital. The others let a few bad trades empty their accounts.
RISK CONTROL TECHNIQUES
There are several ways you can manage risk. First, know your personal risk tolerance. You must have a good idea of the maximum exposure that you are willing to take. Likewise, to apply that self-knowledge, you'll need to calculate the risk of a trade before you take it. Determine the maximum amount of money that could be lost on the trade and honestly ask yourself if you are willing to accept it. If so, consider the trade; if not, walk away.
One great characteristic of the financial markets is there is always another trade. In a few hours or days, there will be another chance to make a trade that better fits your particular risk parameters. Be patient and wait for it.
A day trader, of course, generally makes a lot of trades. Therefore, day traders must manage every trade carefully. That means always using a protective stop and knowing when a loser will be liquidated. It's not a bad idea, for purposes of risk management, to live by the cardinal rule to never trade without a stop. Bottom line, when you assume a position, place a stop loss.
Before making the trade, identify the point at which the market will make clear that the trade is wrong. For example, if buying an S & P contract at 1472.00 and the charts suggest that support should step in at 1469.00; place a protective stop at 1468.50. The reason is simple: If that stop is hit, the market has demonstrated loud and clear that the original analysis was wrong. …