Swing Trading for Dummies Summary (C10): Managing Risk

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You don’t have to be a wiz at picking trades to succeed at swing trading.

In fact, you can be below average and still make a good living.

What's more important is that you have strict risk management rules that you follow religiously.

Even if 70% of your trades are losers, a sound risk management plan (that you stick to!) will ensure your winners outweigh your losses.

Every security has a certain level of risk that you must consider before entering a position.

You can measure this risk by looking at a number of factors. These factors will give you an idea of how much the security’s price may move in the short-term.

Beta: A stock’s beta measures its volatility compared to the overall market. It is derived from historical price movements. The higher the beta, the more volatile the stock is likely to be relative to the market.

Liquidity: This measures how frequently a company’s shares are traded. The more frequent, the easier it is to get in and out of positions. Avoid companies with low liquidity. Also, as a general rule, never buy more than 5% of the average daily volume of a company’s shares.

Company size: Smaller companies generally outperform larger companies in the long run, but they are also more volatile. This is measured as market capitalization, or market cap for short. There are four categories of market cap:

• Large cap: $15 billion or higher
• Mid cap: Between $1 billion and $15 billion
• Small cap: Between $300 million and $1 billion
• Micro cap: Below $300 million

Stay away from micro cap stocks. They have low liquidity and are more susceptible to market manipulation.

Share price: Shares under $5 are considered more risky because they are more susceptible to market manipulation. For example, a rumor in a forum could have a substantial effect on the price.

Limiting your position size in any single security will ensure no single trade can ruin your portfolio.

The first step is to figure out what your maximum possible loss is on a trade.

Sam’s Note: You never want this loss to be more than 1% of your trading capital. Don’t forget to factor in commissions that your broker charges you to make trades.

So if your trading capital is $10,000, you can risk up to $100 on any single position (1% x 10,000 = 100).

Remember, this is not the size of the position. It is the size of your possible loss.

You can position size by applying a blanket percent of capital, e.g, 4%, but it is better to calculate risk on a trade-by-trade basis depending on key exit levels.

This is because every trade setup is different. A blanket percentage ignores important factors such as support and resistance levels.

To calculate risk in this way, you first need to determine your stop-loss, i.e., the price at which you will exit if the trade goes against you.

This stop-loss is determined by your trading strategy. Clear support levels or previous low-swings are often good to use. Once you know your stop-loss you can calculate your possible risk and therefore how many shares you can buy.

Amount of capital at risk / (Entry price - Stop-loss) = Number of shares.

Always round the number of shares down to the whole number so you don’t increase your risk.

When using this method, you must always have a total cap on the amount you invest in any single security. This is because if the gap between your entry and stop-loss is small, then the calculation may have you buying many more shares than you can afford.

Additionally, there is always the chance that the stock will gap past your stop-loss, so you want to put a limit on the true maximum loss, which technically (though not likely) could be the entire position size if going long.

A maximum of 6% of your trading capital is a recommended maximum position size.

And finally, you need to mitigate your total capital at risk. So if all your trades go against you, you will not lose more than a certain percentage of your total capital. When making this calculation, make it relevant to your stop-loss levels, i.e., ignore the possibility of gaps movements.

The recommended total capital at risk is 7%.

The larger amount you risk on a single position, the fewer positions you can hold, and the fewer positions you hold, the more at risk you are.

As a position increases your value you can raise your stop-loss.

Once you get over the break-even point, i.e., the point where your stop-loss is greater than your entry price, your risk level for that position drops to zero. This allows you to risk more capital in other positions since your portfolio risk will have dropped.

Your amount of risk in a position can never be a negative value. Even once you have raised your stop-loss above the break even point to lock in profits, the most your risk level can drop to is zero.

When you invest in more than one security, sector, or trading vehicle you are ‘hedging your bets’.

THis is important for risk management because if you put all your eggs in just a few baskets, if those baskets (securities) fail, you will lose a lot.

On an individual position level, diversification is trading in multiple securities.

Another form of diversification is to ensure your positions are spread out over different industries.

If you are very concentrated in one industry, e.g., technology, and that industry starts to falter, then there is a good chance that most, if not all, technology stocks will drop in price together.

As a general rule, when your portfolio is fully invested (meaning the majority of your trading portfolio is actively in trades as opposed to sitting as cash) you want to have between 10 to 20 positions across five or so different sectors.

However, you do not want to hold more than 20 because it will be too many for you to effectively monitor.

Another way to diversify is to invest in different investment vehicles. When using this approach, aim for at least two different asset classes.

ETFs. An ETF represents a basket of stocks in a sector, style (growth or value), index, country, commodity, currency, etc. It is like instant diversification across a style or sector of the market.

Mixing in international securities is yet another form of diversification. Often when the US market is down, another country is up.

Although not advised, it is possible to be a profitable trader by randomly entering trades as long as your exit strategy cuts losses fast while letting winners ride.

You have several options for exiting when a trade goes your way.

One way is to set a predetermined profit target. If you prefer short term trades, a 5% profit target is recommended. If you prefer to hold onto trades for several weeks, then 10%-15% is not unreasonable.

You can also exit in stages, such as taking 50% profits at a 10% gain and then letting the rest ride. Of course, this takes more effort and comes with more indirect costs such as commissions and taxes.

Another way to set your profit target is with a predetermined price target. This is when you set a specific price point to exit based on a technical or fundamental indicator. For example, when the price hits a point just below a strong resistance level, or at a price multiple based on earnings. When using this strategy, don’t set your sell-price at round numbers or whole dollar amounts. This prevents unfilled orders since many people use those levels to trade at.

You can also exit based on a technical indicator. For example, when the price closes below a moving average, or when the MACD line crosses the signal line. When using this method, ensure the signal is very clear.

A time-based exit can be necessary when the security stale, meaning it is not meeting either your profit target or stop-loss. In these cases, it is often best to get out of the trade so you can free up capital.

The amount of time you wait is up to you. If you are a short term trader (days) then perhaps a week is long enough to wait.

Stop-losses are used to prevent any loss from getting too large. A mental stop-loss is kept in your head (or written down). When a security hits that stop-loss, you will manually exit the position.

A physical stop-loss is an order you submit to your broker at the time you enter the trade. Ensure it is entered as “Good till cancelled” otherwise it will expire at the end of the day.

Inexperienced traders should always use a physical stop-loss.

You can set your stop-loss based on support and resistance levels.

Another option is to exit based on a signal from a technical indicator.

Yet another option is to base your stop-loss on the moving average. You can adjust your stop-loss every other day as the moving average moves.

Don’t get disheartened when you lose a trade. All traders lose trades. It's the ones that don’t react quickly enough that get kicked out of the game.

Remember, cut your losses fast and let your winners ride.

It is extremely important that you put emotions aside and follow your risk management plan. Once you start ignoring a rule here and there, it is a slippery slope. In the long run, it will not end well.

Write down your trading rules and use them as a checklist whenever you enter or exit a position.

Read the next chapter here.

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