The stock market continues to show some optimism, with the key stock indices breaking back above their respective key 50-day moving averages. The DOW turned positive for the year on Wednesday, while the NASDAQ came within one percent of breakeven.
All of this buying is encouraging, but the light trading volume tells us to be careful, as numerous threats remain that could drive fresh 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, that’s fantastic, and you are probably sleeping well at night.
If you have been delinquent in this area, you need to read this.
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. Take the current market rally as an opportunity to take some profits.
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 keep the remaining 50%. Under this simple strategy, you take some profits, but, at the same time, create a zero cost trade, as you have recouped your preliminary 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. But you need to be careful when the volatility increases and wild swings materialize that could take you out of your position prematurely.
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 of 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 with risking. Stops can range from three percent below the purchase price to as much as 15% or more. 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 are referred to as trailing stops and are constantly adjusted as the price of the stock rises. Adopting trailing stops helps to protect your gains as the stock rises.
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% for S&P 500 puts, and 20% for Russell 2000 or S&P 600 Small Cap puts. If you hold only a few large stock positions, you can simply buy corresponding stock puts to match.