By Kerry Szymanski of Harmonic Edge*
Posted: Oct 9, 2009
Every trader needs limits. Unfortunately, one of the things that attract us to trading in the first place is total control because, when we trade, no one tells us what to do or when to do it. This freedom is both a blessing and a curse, depending on how we use it.
Let me illustrate this point by using an analogy. For the person who drinks alcohol in moderation, the freedom to have an occasional glass of red wine is a blessing with well known health benefits. However, the person who fails to set reasonable limits will likely have a very different outcome. Both individuals have the freedom to set limits, but the latter is either unwilling or unable to do so.
We find a similar situation with many traders. No where is this more apparent than in the case of a trader who is either unwilling or unable to consistently follow a trade plan. In what other business would any reasonable person set out to invest large sums of money without a detailed business plan and seriously expect to succeed?
It is beyond the scope of this article to address all of the issues a trading plan should cover, so I will focus on just one -- losses. If you cannot handle taking small losses without feeling miserable, you are probably in the wrong business.
The typical day trader should consider limiting his or her capital exposure to 2 percent per trade. Additionally, the trader should limit losses to 4 percent on any given day. If you are short-term trader with multiple positions, the combined capital exposure should be approximately 5 percent. If you are consistently profitable, you can risk a bit more based on your experience and comfort level.
Returning to our analogy, this is like having one or two drinks on a given day. It is a reasonable limit for most individuals that will likely keep them out of trouble and put them in a position where some good things might happen. Yes, some risk is associated with even moderate drinking, but the benefits usually outweigh the risks.
With respect to trading, I seldom see one caveat mentioned. Our emotions can create enormous problems for us as traders. If not kept in check, our "lizard brain" will quickly convince us that we need to abandon our trade plan and buy when we are excited and sell when we are afraid. We come up with all kinds of excuses to rationalize our behavior, but greed and fear are usually at the root of these kinds of behavior.
Nothing will shift us into "lizard brain mode" faster than the feeling that we have lost too much money on a trade or trade(s) during the course of a day, week or month. This is precisely why we have to "know when to say when".
So, how much is too much? That is difficult to say. Everyone has a different size trading account, circumstances and emotional makeup.
Here are the questions to consider:
- How large is my account?
- What would 2 percent of my account size amount to?
- How do I feel after taking a loss of that size (2 percent of the account)?
- How do I feel taking a second loss of that size on the same day?
- Am I able to close the brokerage screen on my computer and walk away when I’ve taken my maximum loss?
- Am I able to start the next day fresh and ready to stick with my plan?
It is crucial that you find a risk level that you can completely accept so that the outcome of one or two trades is basically meaningless -- nothing more than a blip or two on your spreadsheet or trade log.
Regardless of what market you are trading, you should have the research in hand that shows precisely how much you must risk on a trade to find out if you are right. If you are wrong on a trade, you need to be able to close the position effortlessly and get on to the next trading opportunity.
It may be that you can only emotionally afford to trade one contract or a relatively small number of shares. That is fine -- this gives you something to build on. It is important that you get comfortable with the idea of losing modest amounts of money because the alternatives are to lose large sums of money, lose all of your money or not trade at all.
Losses are a cost of doing business as a trader and cannot be avoided because no one can possibly be correct all of the time.
There is nearly complete freedom in the trading business, but you have to "know when to say when". Otherwise, you will "tie one on", and a trading hangover will prevent you from generating consistent profits.
*Reprinted (and modified) with permission from Kerry Szymanski
