Chapter 3:
Risk and Account Management
To be a successful day trader, you need to master three essential components of trading: sound psychology, a series of logical trading strategies, and an effective risk management plan. These are like the three legs of a stool - remove one and the stool will fall. It is a typical beginner’s mistake to focus exclusively on indicators and trading strategies.
A good trading strategy delivers positive expectancy; it generates greater profits than losses over a period of time. All of the strategies outlined in Chapter 7 have been demonstrated, if executed properly, to show positive expectancy. But, keep in mind, even the most carefully executed strategy does not guarantee success in every trade. No strategy can assure you of never having a losing trade or even suffering a series of losing trades. This is why risk control must be an essential part of every trading strategy.
The inability to manage losses is the number one reason that new traders fail in day trading. It’s a common human inclination to accept profits quickly and also to want to wait until losing trades return to even. By the time some new traders learn to manage their risk, their accounts are badly, if not irreparably, damaged.
To be a successful trader, you must learn risk management rules and then firmly implement them. You must have a line in the sand that tells you when to get out of the trade. It’s going to be necessary from time to time to admit defeat and say, “I was wrong,” or “The setup isn’t ready yet,” or “I'm getting out of the way.”
I’m generally a successful trader, but I still lose frequently. That means I must have found a way to be a really good loser. Lose gracefully. Take the losses and walk away.
I can’t emphasize enough how important it is to be a good loser. You have to be able to accept a loss. It’s an integral part of day trading. In all of the strategies that I explain in Chapter 7, I will let you know what is my entry point, my exit target, as well as my stop loss.
You must follow the rules and plans of your strategy, and this is one of the challenges you will face when you are in a bad trade. You may very likely find yourself justifying staying in a bad trade by saying, “Well, you know, it's Apple, and they make really great smartphones. They're definitely not going out of business. I'll just hold this a little longer.”
You do not want to do that. You must follow the rules of your strategy. You can always get back in, but it’s hard to recover from a big loss. You may think, “I don't want to take a $50 loss.” Well, you definitely don't want to take a subsequent $200 loss. And if you ended up taking an $800 loss, it would be really hard to recover from that. Take the quick losses, get out, and come back when the timing is better.
Every time you trade, you’re exposing yourself to the risk of losing money. How do you minimize that risk? You need to find a good setup and manage the risk with proper share size and stop loss.
Here is my next rule:
Rule 5: Success in day trading comes from risk management - finding low-risk entries with a high potential reward. The minimum win:lose ratio for me is 2:1.
A good setup is an opportunity for you to get into a trade with as little risk as possible. That means you might be risking $100, but you have the potential to make $300. You would call that a 3 to 1 profit-to-loss ratio. On the other hand, if you get into a setup where you're risking $100 to make $10, you have a less than 1 risk-reward ratio, and that's going to be a trade that you should not take.
Good traders will not take trades with profit-to-loss ratios of less than 2 to 1. It means if you buy $1,000 worth of stock, and are risking $100 on it, you must sell it for at least $1,200 so you will make at least $200. Of course, if the price comes down to $900, you must accept the loss and exit the trade with only $900 ($100 loss).
If you cannot find a setup with a good profit-to-loss ratio, then you should move on and keep looking for another trade. As a trader, you are always looking for opportunities to get low risk entries with big win potential. Being able to identify setups that have big win potential is also part of the learning process. As a beginner trader you may not be able to differentiate between a range of setups. It may be difficult for you to recognize what is a home-run Bull Flag and what will end up being a “false breakout”. That’s something that comes with both experience and training. We will cover this in more depth in the coming chapters. You can learn from videos on YouTube and Google. You can also join our private chatroom (free to you) in www.Vancouver-Traders.com where I explain my trades in real time while I am trading them. You will be able to observe me and my monitor and my trading platform.
Using a 2 to 1 win:lose ratio, I can be wrong 40% of the time and still make money. Again, your job as a day trader is managing risk, it is not buying and selling stocks. Your broker is buying and selling stocks for you in the market. Your job is to manage your risk and account. Whenever you click “buy” in your trading platform, you expose your money to a risk.
How do you manage that? You essentially have three steps in managing risk. You need to ask yourself:
- Am I trading the right stock?
Chapter 4 focuses on finding the right stocks for day trading. I will explain in detail how to find stocks that are suitable for day trading and what criteria you should look for in them. You must avoid stocks that (1) are heavily traded by computers and institutional traders, (2) have small relative trading volume, (3) are penny stocks that are highly manipulated, and (4) don’t have any reason to move (no fundamental catalysts). I will explain these in more detail in Chapter 4. Do remember that risk management starts from choosing the right type of stock to trade. You can have the best platform and tools and be a master of strategies, but if you are trading the wrong stock, you will definitely lose money.
- What share size should I take?
One share, 10 shares or 100 shares? What about 1,000 shares? This depends on your account size and your daily target. If you are targeting $1,000 a day, then 10 or 20 shares might not be enough. You either have to take more shares or increase your account size. If you don’t have enough money to trade for a $1,000 daily target, you should lower your daily goal.
I am holding around $25,000 in my trading account and I usually choose 800 shares to trade. My daily goal is $500 or $120,000/year. That is sufficient for my lifestyle. What is your trading goal?
- What is my stop loss?
The absolute maximum a trader should risk on any trade is 2% of his or her account equity. For example, if you have a $30,000 account, you should not risk more than $600 per trade, and if you have a $10,000 account, you should not risk more than $200. If your account is small, limit yourself to trading fewer shares. If you see an attractive trade, but a logical stop would have to be placed where more than 2% of your money would be at risk, then pass on that trade and look for another one. You can risk less, but you should never risk more. You must avoid risking more than 2% on a trade.
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