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Live to Trade Another Day: 5 Risk Management Ideas to Consider
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Thinking in Bets
Legendary trend follower Larry Hite has some wise words for investors:
“I have two basic rules about winning in trading as well as in life.
1.) If you don’t bet, you can’t win.
2. If you lose all your chips, you can’t bet.”
My Interpretation of Hite’s quote is that it is impossible to eliminate risk if you want to make money in the stock market. However, you can control that risk and win over time through risk management measures.
“Landmines” can Increase Risk
No other time is the quote more relevant than during earnings season. Take, for example, ride-sharing giant Lyft (LYFT - Free Report) . Last week shares plummeted 36% overnight after reporting disappointing earnings.
Image Source: Zacks Investment Research
Meanwhile, without warning, Credo Technology (CRDO - Free Report) dumped more than 45% overnight on news that the high-speed networking provider’s largest customer was cutting demand. To make matters worse, the company lowered Q4 guidance from $54-56 million to $30-32 million.
Image Source: Zacks Investment Research
Risk Mitigation is Paramount
Regardless of experience, trading talent, or strategy, the best investors in the world have losing trades. Because of this, perfectionists tend to do poorly on Wall Street. What separates the profitable from the unprofitable trader over time is the ability, discipline, and know-how to prepare and manage risk ahead of time. Here are 5 things to think about when planning your risk management:
1. Weigh Position Sizing: Position sizing is the true means of managing risk when trading common stock. In either gap-down example mentioned above, stop losses would not have been helpful because the stocks took on selling overnight. Remember, the only way to survive overnight gap-down risk is through proper position sizing.
2. Think in a Series of Trades:Due to the short-term randomness of the stock market, anyone can make money on a single trade. You can have a baby throw a dart at a sheet of stocks, and there is a good chance it will go up. However, one trade is not important. The long-term results of thousands of trades are what matters. In the long-term, the process supersedes the outcome of any given trade. For example, if you had ten winning trades in a row and then had an oversized position in Credo Technology this week, you ended up negating those trades.
3. Be Prepared for Anything:Though traders could have known that Lyft was set to report earnings and volatility could pick up, in Credo’s case, there was no way of knowing that bad news would come out overnight. The unpredictability of the stock market underscores why thinking about risk ahead of time is so critical. Think about risk before entering a trade. Ask yourself, “would I survive a 50% gap down with my current position size in this stock?” If the answer is no, decrease your position size or exit the stock.
4. Listen to your Emotions:If you find that you are watching every tick on your stock, can’t sleep, or feel like you won or lost the Super Bowl, depending on the outcome – you are likely trading too large. Too much size can lead to poor decision-making under pressure. Too much size is akin to throwing gas on a fire. Position size in such a way that you are even keel and not overly concerned about the outcome of a single trade.
5. Develop an Investing Framework: Investors who trade solely based on gut feeling are setting themselves up for disaster. Instead, stave off biases by developing a proven strategy and a probabilistic mindset.
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Live to Trade Another Day: 5 Risk Management Ideas to Consider
Thinking in Bets
Legendary trend follower Larry Hite has some wise words for investors:
“I have two basic rules about winning in trading as well as in life.
1.) If you don’t bet, you can’t win.
2. If you lose all your chips, you can’t bet.”
My Interpretation of Hite’s quote is that it is impossible to eliminate risk if you want to make money in the stock market. However, you can control that risk and win over time through risk management measures.
“Landmines” can Increase Risk
No other time is the quote more relevant than during earnings season. Take, for example, ride-sharing giant Lyft (LYFT - Free Report) . Last week shares plummeted 36% overnight after reporting disappointing earnings.
Image Source: Zacks Investment Research
Meanwhile, without warning, Credo Technology (CRDO - Free Report) dumped more than 45% overnight on news that the high-speed networking provider’s largest customer was cutting demand. To make matters worse, the company lowered Q4 guidance from $54-56 million to $30-32 million.
Image Source: Zacks Investment Research
Risk Mitigation is Paramount
Regardless of experience, trading talent, or strategy, the best investors in the world have losing trades. Because of this, perfectionists tend to do poorly on Wall Street. What separates the profitable from the unprofitable trader over time is the ability, discipline, and know-how to prepare and manage risk ahead of time. Here are 5 things to think about when planning your risk management:
1. Weigh Position Sizing: Position sizing is the true means of managing risk when trading common stock. In either gap-down example mentioned above, stop losses would not have been helpful because the stocks took on selling overnight. Remember, the only way to survive overnight gap-down risk is through proper position sizing.
2. Think in a Series of Trades:Due to the short-term randomness of the stock market, anyone can make money on a single trade. You can have a baby throw a dart at a sheet of stocks, and there is a good chance it will go up. However, one trade is not important. The long-term results of thousands of trades are what matters. In the long-term, the process supersedes the outcome of any given trade. For example, if you had ten winning trades in a row and then had an oversized position in Credo Technology this week, you ended up negating those trades.
3. Be Prepared for Anything:Though traders could have known that Lyft was set to report earnings and volatility could pick up, in Credo’s case, there was no way of knowing that bad news would come out overnight. The unpredictability of the stock market underscores why thinking about risk ahead of time is so critical. Think about risk before entering a trade. Ask yourself, “would I survive a 50% gap down with my current position size in this stock?” If the answer is no, decrease your position size or exit the stock.
4. Listen to your Emotions:If you find that you are watching every tick on your stock, can’t sleep, or feel like you won or lost the Super Bowl, depending on the outcome – you are likely trading too large. Too much size can lead to poor decision-making under pressure. Too much size is akin to throwing gas on a fire. Position size in such a way that you are even keel and not overly concerned about the outcome of a single trade.
5. Develop an Investing Framework: Investors who trade solely based on gut feeling are setting themselves up for disaster. Instead, stave off biases by developing a proven strategy and a probabilistic mindset.