Limiting Losses
By Jason Van Bergen
It is simply not possible for any trader--whether amateur, professional or
anywhere in between--to avoid every single loss. The disciplined trader is
fully cognizant of the inevitability of losing hard-earned profits and, as
such, is able to accept losses without emotional upheaval. At the same time,
however, there are systematic methods by which you can ensure that losses
are kept to a minimum.
The System
Every trader should employ a loss-limit system whereby he or she limits
losses to a fixed percentage of assets, or a fixed percentage loss from
capital employed in a single trade. Think of such a system as a circuit
breaker, or collar, on the trade. After a certain percentage has been lost
from his or her trading account or principal traded, the trader may very
well stop trading entirely or may immediately exit the losing position. With
this system, exiting a losing position is a single, unemotional decision
that is not affected by any hopes that "the market is sure to turn around
any minute now."
A 2% Limit of Loss
A common level of acceptable loss for one's trading account is 2% of equity
in the trading account. The capital in your trading account is your risk
capital, the capital that you employ (that you risk) on a day-to-day basis
to try to garner profits for your enterprise.
The loss-limit system can even be implemented before entering a trade. When
you are deciding how much of a particular trading instrument to purchase,
you would simultaneously calculate how much in losses you could sustain on
that trade without breaching your 2% rule. When establishing your position,
you would also place a stop order within a maximum of 2% loss of the total
equity in your account. Of course, your stop can be anywhere from a 0% to 2%
total loss. A lower level of risk is perfectly acceptable if the individual
trade or philosophy demands it.
Every trader has a different reaction to the 2% rule of thumb. Many traders
think that a 2% risk limit is too small and that it stifles their ability to
engage in riskier trading decisions with a larger portion of their trading
accounts. On the other hand, most professionals think that 2% is a
ridiculously high level of risk and prefer losses to be limited to around
half or one-quarter of a percent of their portfolios. Granted, the pros
would naturally be more risk averse than those with smaller accounts--a 2%
loss on a large portfolio is a devastating blow. Regardless of the size of
your capital, it is wise to be conservative rather than aggressive when
first devising your trading strategy.
Monthly Loss Limit of 6%
So, you have now established a system whereby your loss from each
individual trade is limited to 2% of your risk capital. But it doesn't take
a rocket scientist to realize that even losing a moderate 1% of your
account's value in ten days within a month results in a rather devastating
10% of your account's value within that month (notwithstanding any profits
that you might have made in the other twelve-odd trading days within the
month). In addition to limiting losses from individual trades, we must
establish a circuit breaker that prevents extensive overall losses during a
period of time.
A useful rule of thumb for overall monthly losses is a maximum of 6% of your
portfolio. As soon as your account equity dips to 6% below that which it
registered on the last day of the previous month, stop trading! Yes, you
heard me correctly. When you have hit your 6% loss limit, cease trading
entirely for the rest of the month. In fact, when your 6% circuit breaker is
tripped, go even further and close all of your outstanding positions, and
spend the rest of the month on the sidelines. Take the last days of the
month to regroup, analyze the problems, observe the markets, and prepare for
re-entry when you are confident that you can prevent a similar occurrence in
the following month.
How do you go about instituting the 6% loss-limiting system? You have to
calculate your equity each and every day. This includes all of the cash in
your trading account, cash equivalents, and the current market value of all
open positions in your account. Compare this daily total with your equity
total on the last trading day of the previous month and, if you are
approaching the 6% threshold, prepare to cease trading.
Employing a 6% monthly loss limit allows the trader to hold three open
positions with potential for 2% losses each, or six open positions with a
potential for 1% losses each, and so forth.
Making Necessary Adjustments
Of course, the fluid nature of both the 2% single trade limit and the 6%
monthly loss limit means that you must re-calibrate your trading positions
every month. If, for example, you enter a new month having realized
significant profits the previous month, you will adjust your stops and the
sizes of your orders so that no more than 2% of the newly calculated total
equity is exposed to a risk of losses. At the same time, when your account
rises in value by the end of the month, the 6% rule of thumb will allow you
to trade with larger positions the following month. Unfortunately, the
reverse is also true: if you lose money in a month, the smaller capital base
the following month will ensure that your trading positions are smaller.
Both the 2% and the 6% rule allow you to pyramid, or add to your winning
positions when you are on a roll. If your position runs into positive
territory, you can move your stop above break-even and then buy more of the
same stock--as long as the risk on the new aggregate position is no more
than 2% of your account equity, and your total account risk is less than 6%.
Adding a system of pyramiding into the equation allows you to extend
profitable positions with absolutely no commensurate increase in your risk
thresholds.
Conclusion
The 2% and the 6% rules of thumb are highly recommended for all traders,
especially those who are prone to the emotional pain of experienced losses.
If you are more risk averse, by all means, adjust the percentage loss
limiters to lower numbers than 2% and 6%. It is not recommended, however,
that you increase your thresholds--
potential for losses, so do think twice before you increase your risk
thresholds.
Until next time, all the very best in your trading endeavors!
Regards,
Regards
Puja Singh
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