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"Plan the trade and trade the plan". This is possibly one of the most cliched phrases in trading yet many traders still fail to realise its importance. Creating a trading plan simply means having a strategy in place (before the trade is made) that determines the amount of trading capital that should be placed at risk for the trade (and therefore the amount traded). The strategy should include the price of the underlying security when entering the trade and two exit prices. One exit price should be the target price (and the price that a profit should be taken) and the other should be a stop loss price (the price at which the trader is prepared to take the maximum loss if the trade does not proceed as planned). The price that a trader should enter and exit the trade has been covered in detail in previous lessons. This lesson is more concerned with the decisions on how much trading capital should be placed in a single trade. The lesson also reaffirms the importance of having an exit strategy in place before entering the trade.
Possibly the most important point regarding a trading plan is sticking to it. Many traders create excuses to break away from their trading plan and this inevitably ends in disaster. The advantage of creating a trading plan before beginning to trade is that the plan can be made without any emotion relating to the profit or loss of a current position in the market. Never make up the trading plan as you go. Always have the plan ready before you begin trading. Once the plan is in place, stick to it and give it a chance. Don't go changing the plan after closing every position. In all likelihood, your original plan is probably the best one and there is no point changing it because it didn't work so well for the first few trades.
A common trap for inexperienced traders is losing the original trading capital because they went into too risky trades with too much of the original capital. If a trader was to lose half of the trading capital in the first trade, this requires the trader to earn a return of 100% of whatever capital they have left just to gain back their original trading capital. It is important when first starting with trading capital, to minimise the risk as much as possible. The trader can begin to take larger risks when they begin to 'play with profits', that is, they have made a profit on their original trading capital and any loss will come out of the profits. However, if the strategy is working, there may be little reason to change the strategy and the only adjustments made should concern the actual amount of capital traded as there will now be more capital to trade with.
Many people fail to make profits simply because they are unable to keep to a trading plan. Why is it so hard to keep to a plan? The answer is simply because we are human and our decisions are based on emotions - namely fear and greed. When we enter a trade we are driven by greed to make money. When closing a trade, we are subject to the emotions of fear - fear that the stock may fall in price or fear that the stock will continue to rise and we will miss out on extra profits. Anyone who denies this and maintains that they trade without emotion is only kidding themselves. Human beings cannot escape these emotions and it is usually these emotions that attract traders to the market in the first place. The key to successful trading is to control these emotions and keep their influence on trading decisions to a minimum. Analysis of the markets is useless unless the trader has the discipline to execute the trade based on the analysis. Too often, the trader will adjust the execution of the trade because of fear or greed. A successful trader will have some emotions of fear and greed. This is good because it is essential for survival in the market. Imagine if someone just entered trades without any fear of loss - they would trade anything at any risk. If they traded without greed it is unlikely they would have ever wanted to trade the market in the first place. Successful traders are able to control emotion and keep its influence on trading decisions to a minimum.
There is no single piece of advice that can be given in terms of controlling emotions. Each person has different levels of fear and greed and will have to control them in a manner that suits them. Traders try various techniques to control emotions. One example is to try and not equate trading with real money or equate trading profits and losses with material value. For example, someone may execute a trade and the trading strategy suggests that a profit of $800 is the profit target. However, when the stock is at a price that would give the trader a profit of $400, the trader may equate this as being a new fridge or a short holiday. Likewise when having to stop out of a stock, traders may consider that the loss as being equal to a new television and therefore do not stop out because the loss is too great. Traders often try and remove themselves from the 'real world' when trading. Taking a loss that equates to two days salary is something that is very hard to do when it is considered like that. But if a trader loses sleep over two days of salary when trading, they probably shouldn't be trading! Try and think of the prices and volume of stock as numbers with no material value. This in turn will often reduce the amount of fear and greed that influences your trading.
Another common method is to let the broker execute the trade for you. By telling the broker the entry price and the two exit prices if the entry price is filled, the trader has no need to watch the stock for when it hits either of these prices. They only need to wait until the broker rings them to find out the outcome of the trade. By not 'tracing' the trade, the trader is largely unaffected by fear and greed and the temptation to close the trade at a different price other than that given to the broker.
Some traders believe in relaxation techniques to clear the mind, others rely on drugs such as caffeine to 'pump them up'. This last method is possible more a means of reducing fear than anything else. In any case, try some different methods yourself if you are having problems with keeping to a trading plan. The importance of this cannot be stressed enough.
So we have seen that a key element of a trading plan is discipline - the ability to stick to the plan. Earlier, we touched briefly on deciding how what risk to take in each trade and the importance of keeping with a plan. The question now arises, exactly how much should we put at risk on each trade? Is there an optimal solution? The answer is 'No', there is no optimal solution. This is because each trader will have different adversities to risk. A single parent with a mortgage and seven children to support will have a different investment risk profile to a young person with no dependents or debt and has just won lotto. Each trader must create their trading plan and ultimately answer the question, "If I were to lose this money, would my life be adversely affected by it?" If you can answer 'No' to this question when entering a trade, then you are probably trading the right amount of capital. It has to be remembered that our lives will be somewhat adversely affected when losing money in the market because at the least, we will be disappointed with the result. 'Adversely affected' will be different for us all. If even losing a single cent on the market will have you awake at night and scrounging around for money for your next rental payment, you should not be investing in the stock market. If, however, the only effect on your life after losing money in a trade is disappointment, you probably have an adequate capital base to trade.
It is important to note that when talking about capital at risk (the amount that can potentially be lost in a trade), we are not always talking about the full amount of the investment. Say a trader had $30,000 as their trading capital and they wished to buy Newscorp shares at $15.00 with a profit target of $16.50 and a stop loss of $14.50. How much should they place on the trade? If the trading plan says to only risk 1% of capital in any one trade, does this mean the trader can only buy $300 worth of shares? (20 shares). This would certainly be the case if there was a strong likelihood of the company going to a share price of $0. However, the trader believes that this is extremely unlikely and that he will have plenty of opportunity to hit the stop loss at $14.50 should the share trade down to this price. He has now decided then that the most the share can drop is 50 cents, not $15.00. Therefore, with 1% of trading capital still being $300, the trader will now buy 600 shares ($300/$0.50). 600 shares will cost the trader $9,000. This is 30% of the capital ($9,000/$30,000 * 100) but if the trader can stop out at $0.50 below the current market price, he is still only placing 1% of the trading capital at risk.
Take another example where the same trader believes a $0.030 share is going to break out up to $0.040. The stop loss is going to be $0.025. How much should they invest in this stock? $300 is the capital to place at risk and the downside is ½ a cent. $300/$0.005 = 60,000. In other words, if the trader bought 60,000 shares and believed it was more than possible to sell the shares at $0.025 cents, the loss would be $300, which equals the capital at risk. 60,000 at $0.03 will cost the trader $1,800.
The point of the above examples is to illustrate that the actual amount invested is not as important as calculating (albeit an approximate calculation because it is based on a non-exact parameter of risk) the amount of money at risk. In the first example, the trader buys $9,000 worth of shares and in the second example, only $1,800 worth. However, the estimated capital at risk remained the same.
So what should the capital at risk be? This is a key parameter that each individual trader must decide. The single parent will have a lower capital at risk percentage than the lotto winner. Through experience, each trader will develop their own risk adversity.
'Risk/Reward Ratio' is an expression commonly used in trading and it is designed to seek out trades where the reward is worth the risk taken. Say a stock is currently under takeover and if the takeover goes ahead, the stock will go from the current price of 50 cents to the takeover price of 60 cents. This may seem a good return but what if the takeover didn't go ahead and the stock was to return to the 'pre-takeover price' of 30 cents. In this scenario, the reward is 20% of the investment yet the risk is 40% percent of the investment. Many traders would immediately dismiss this as a trade and look elsewhere. The risk reward ratio is just not great enough.
So what is an adequate risk/reward ratio? Again, this can only be answered by the individual trader and comes back to their adversity to risk. A ratio of 1:3 may be adequate for beginners. That is, trading in stock where the likely downside is 1/3 of the likely downside. For example, a trader believes that a stock trading at $1.00 has the potential to trade up to $1.30 but could also trade down to 90 cents at which point the trader would stop out. The risk reward ratio is 1:3, or just 3.
If a trader were to wait for trades that had a risk reward ratio of 1:10, wouldn't this be an ultra-safe strategy and prove profitable? On the surface it might, however, trades that present these opportunities are very rare and the trader may miss out on many other profitable trades waiting around for high-risk reward ratios. Traders should find a balance between risk, reward and opportunity.
This has been a short lesson designed simply to outline the importance of managing risk. The chief instrument in achieving this is a robust trading plan that takes into account the traders level of capital and adversity to risk. Every trader experiences the emotions of fear and greed. A profitable trader is able to maintain the discipline necessary to keep to a trading plan. A rich trader has discipline and has mastered control over his emotions.