How an Investor Can Sleep Better at Night

There is again some buying optimism on Wall Street, but be careful, as there continues to be many threats that could drive renewed selling. You need to understand that being prudent is important for success.

The reason why I want to briefly talk about risk management is my sense that there are some of you who probably fail to incorporate some sort of risk management strategy. If you do use one, that’s fantastic and you are probably sleeping well at night. If you have been delinquent in this area, you are probably stung at this moment and thinking about how you are going to get back your trading capital.

I have been involved in the markets for over 20 years. After reading the strategies of some of the world’s best traders, a commonality surfaces: the most important tenet in trading is preserving your investable capital via the use of risk management. The last thing you want to happen to you is to trade sloppily and lose your tradable capital. Instead of being a player in the exciting world of trading, you would be relegated to watching from the sidelines. But, guess what? You can avoid this by following some simple strategies.

When the price of a stock trends higher, you should always think about a potential exit strategy. This does not mean liquidating profitable trades, but rather protecting your unrealized gains.

If you have a price target for your stock, you can sell the stock when it reaches that target. Alternatively, if the gains are significant, you can take profits on a portion of the position and let the remaining portion ride. For instance, if a stock rises by 100%, you can liquidate 50% of the position and let the remaining 50% ride. Under this simple strategy, you realize some profits, but, at the same time, create a zero cost trade as you have already recouped your original investment. You can view the remaining 50% stake as risk capital.

Another strategy that needs to be considered is the use of mental or physical stop-loss limits. The reality is that no one is perfect in trading. I make mistakes and so do many of you. If you can accept this, then that’s half the battle. To protect against mistakes, you should use stop-losses on your positions. Where to place the stop depends on how much capital you are comfortable risking. Stops can range from three percent below the purchase price to as much as 15%. Setting a close stop can take you out quickly in a fast market. Conversely, setting the stop too low can entail large losses.

Stops should also be used when a stock is trending higher. These stops, referred to as “trailing stops,” are constantly adjusted as the price of the stock rises. This can easily be done in a spreadsheet or by hand. Adapting trailing stops helps to protect your gains as the stock rises.

Some of you may be wondering if the stop-loss should be a mental or physical stop. I prefer a physical stop, as it effectively eliminates the potential influence that emotion can play when you trade. I’m going to say it here. EMOTION kills good trades and often makes you keep your losers. Keeping losers is counterproductive and turn you into a viewer from the sidelines. EMOTION has no role in trading. I consider EMOTION the cancer of trading and it needs to be eradicated!

For those of you familiar with options, you can employ a “Put Hedge” or “Protective Put” to help minimize the downside loss. If you own mutual funds, you can buy the appropriate index Put by determining the type of fund it is (e.g. small-cap, blue-chip, S&P 500, technology, etc.).

If your portfolio is 50% technology, 30% large-cap, and 20% small-cap, you can hedge the risk by allocating 50% to Puts on the NASDAQ 100, 30% to S&P 500 Puts, and 20% to Russell 2000 or S&P 600 Small Cap Puts. If you hold only a few large positions — say Microsoft, Pfizer, General Electric, Citigroup and Home Depot — you can simply buy corresponding Puts to match.

Understand what I have discussed. If you are already adhering to risk management strategies, good for you; otherwise, learning them will make you a better and more successful trader.