We are closing in on the end of our blog overviews of the Foundations of Stocks and Options Level 3 class teachings, and it is time to take a more in-depth look at risk management as it was presented in class 7. After all, many people trade the stock market, and there are many people making money trading the stock market. Statistically, most people will deplete their trading accounts more than once, meaning they will lose most if not all of their trading capital on bad trading decisions. But this trend is far from guaranteed as the secret to avoiding losing your trading account’s capital is by practicing risk management and money management.
Risk management is the process of identifying areas of vulnerability in investment decisions and putting processes in place to minimize your risk exposure. After all, there is always a chance you will lose money on any trade; however, there are a few steps you actively take to protect yourself from significant losses in the marketplace.
Stay away from risking your entire trading account on a single trade. Simply put, make sure you limit the amount of capital you have on the line for each trade. Stay away from risking money you cannot afford to lose. In other words, trade with money you can walk away from instead of borrowing cash from someone or even yourself via credit cards to fund your trading account. Finally, always be prepared for the speed with which all your fortunes can turn against you. The stock market can turn around at the speed of a tweet or news article, so plan for the best but always prepare for the worse.
We already mentioned this earlier in the blog, but it is important to bring it up again. Avoid risking your entire trading account on a single trade. Unfortunately, we have heard more than our fair share of this happening to people with real money accounts. We recommend putting less than 5% or lower of your trading account on any given trade.
Second, diversifying your trading account across various sectors is a better approach to keeping your invested capital secure. When you spread your trades out, it can keep your invested capital protected because if one sector of the marketplace hits a bearish downturn, it might not touch other sectors. An event that is causing the retail sector to plunge might cause the energy sector to profits.
Third, always use stops. This point should be set in stone for every trader as stops protect your account from dramatic losses. Thus, if a trade turns against you having a stop set will protect your account against a runaway plummet. You might still lose some capital on the trade but depending on where your stop was set; it could be the difference between losing a few dollars to wiping out your entire trading account. On a side note, the most important rule of stops is setting the stop where the chart dictates it needs to go compared to where you feel it needs to go. At Tradesmart, we tend to base our stops on moving averages high or low swing points.
Finally, it never hurts to practice capital extraction. This is where you regularly move money you have earned trading out of your trading account. Once you have established your trading account to a satisfactory level of capital, which provides you the freedom to make most of the trades you wish, we recommend removing the extra cash you have generated from trading. This will keep you out of the mindset of: I have money to play around with, or I have money which I can afford to lose.
In closing, any type of trading will have a measure of risk associated with it; however, how well you prepare for any inevitable risk will determine how long you will be able to stay in the game. So do your due diligence, keep your eye on the outcome, and always prepare for the worst as it will keep your capital protected and your account in the green.
Thank you so much for reading, and as always, if you wish to learn more regarding this topic, please consider signing up for our Foundations of Stocks and Options class, which you can do here, and we look forward to seeing you in our next Foundations of Stocks and Options blog which will cover the final class in FOSO Level 3!