An extremely important aspect of trading is your money management plan. There will be orders that go against you in the market, it is inevitable. It is simply not possible for any trader, professional, amateur, or anyone in between to avoid all losses. Knowing ahead of time there will be losses, but having a management plan in place will not only keep you financially in the game but will keep you emotionally in the game.

Many traders will tell you to set a predetermined maximum acceptable loss based on your personal account size. Another method of managing you account is to set stop loss orders at an arbitrary percentage of the purchase price you are willing to lose. I will go over these well known systematic methods that you can ensure will help keep losses to a minimum.

The 2% Stop Loss Limit

One line of thought is to loss no more then 2% of your total trading account on any one trade. To keep numbers simple lets say you have $60,000.00 available for trading. Your maximum 2% loss on any given trade would be $1200.00. Let’s say XYZ stock is giving us a buy at $10.00, and we were to risk $6,000 by buying 600 shares we would place our 2% stop loss at $8.00 the predetermined maximum acceptable loss of $1200.00 on this trade.

Another extremely popular method is to never risk more than 2% of a position. Using the example from above, you would set your stop loss order at $9.80 risking $120.00 on an order for 600 shares. 

The 8% Stop Loss Limit

William O'Neil, publisher of Investors Business Daily, states that you should never lose more than 8% of your position on any given trade. In the case of the above example you would place your stop loss order at $9.20 or 8% below $10.00 risking $480.00 on an order for 600 shares. 

The 10% rule 

Another method is to trade no more then 10% of total trading capitol on any given trade. If you have a $60,000.00 trading account, your maximum dollar amount per trade would be $6,000.00 or for example 300 shares of a $20.00 stock. Implementing a stop loss plan with this style of money management will ensure you can endure a string of losses and still be in the game.

Risk to reward ratio

The Risk to Reward Ratio is commonly used by investors to compare the expected returns of an investment to the amount of risk undertaken to achieve these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction (i.e. the risk).

For example, a trader purchases 100 shares of XYZ Company at $20 and places a stop loss order at $15 to ensure losses will not exceed $500. Let us also make the assumption that this trader believes the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing the position. Since the trader stands to make double the amount of the loss they would have a 2:1 risk/reward ratio on that particular trade.

Overview   

Every trader has a different reaction to the 2% and or the 8% rule of thumb. We think that 2% of your entire trading account is an exceptionally high amount to lose per trade, on the other hand 2% of a position might cause you to be stopped out due to normal market volatility. For swing or trend trading purposes we also feel 8% losses per trade is also an exceptionally high amount to lose.  

Having gone over these methods, and I will admit they are valuable in preventing large draw downs in your account balance, but they really have nothing to do with the stocks behavior. Another method and the one we prefer is to base our stop loss orders on technical indicators such as support and resistance levels, the average true range a stock travels every day, as well as hourly and daily charts. Analyzing each trade based on these indicators and keeping losses in the 2 to 6% range seems to be a good balance in keeping losses small but also keeps us from being stopped out of trades under normal market conditions. 

There are many different ways to manage your account and it is important to devise a plan that is comfortable for you. The bottom line is to have some kind of plan and implement it before each trade. It is easy to look at a trade in terms of how much money you will make, we believe it is even more important to consider how much you are willing to lose.

Michael