Contrary to the popular belief that trading is all about finding the right patterns and get in, risk management contributes at least by 50% in trading success. It is more possible to be successful by entering trades by chance and applying a good risk management, than finding and entering in the best chart patterns without risk management at all. In the last case the one trade that will go wrong will reap out your whole capital.
Due to the mundane and less impressive nature of risk management, it tends to be underestimated by some traders even professionals (see famous bankruptcies of high esteemed hedge funds and financial institutions). As everything in trading, risk management has to be confined on easy to comprehend simple rules. Below are the most important.
1. Never risk more than 2%-3% of your capital in any trade
This gives somebody the opportunity to lose many trades in a row and still have capital to recover from losses. Also it gives traders time to think if something is wrong with their strategy.
2. Never use more than 1/3 (33%) of your cash balance in any swing position
3. Trade only with money you don’t need
Trading, especially for a new trader, imposes the risk of total capital loss. These money should’t be needed to satisfy basic life necessities. Moreover, “scared” money will blur objective judgement and make a trader taking sentimental decisions. In that case it’s only a matter of time to lose their capital.
4. Never borrow from a bank to trade
Borrowing from a bank is completely different from leverage. In the first case someone has to return the capital plus interest via monthly payments. In the second case someone borrows for a short term period, with very low interest and when closing the position they owe nothing.
5. A trader must always use stop orders (mental or physical)
Stop orders are risk management applied to particular trades and it contributes at least 50% in trading success.
6. Short sell preferably medium to high capitalization stocks
In order to avoid a buyout when someone has a short position. Medium to high capitalization stocks are expensive enough to be targets of acquisitions.
7. Start trading with a small portion of your money and treat it like it was 10 million dollars
A new and inexperienced trader must start trading with a small portion of their cash and be prepared to lose it all but without having economic difficulties afterwards. A new trader must be prepared for the worst even if he/she finally succeed. He/she must treat these money, even if we are talking about $2000, like it was $10 million. If you learn how to be successful by trading with only a small amount you can do it exactly in the same way by having a much larger amount.
8. Never adding money to a losing trading account
If as a new trader you are losing money don’t add more to your trading account. Most probably you will keep on losing every new dollar you are putting in. Add only if you have find the way to be long term profitable.