Share Trading School

Your long term success as a trader depends on how you manage risk in the market. The golden rule of trading, "let your profits run and cut your losses short", is all about managing risk and taking measures to limit your losses. Risk is an essential part of trading and in order to protect your capital, you need to avoid risks that will put you out of business.

Risk and money management form the most critical parts of your trading plan. Just like any business, in order to survive, it needs to have a plan. This plan is individually based and is a blue print of your trading future. It should set out your trading style, goals and objectives, strategies and tactics and most importantly risk and money management.

When starting out amateur traders are mostly interested in entry methods, yet it is money management that is the key to survival. You can get almost everything else in your plan wrong, but if you have strict money management rules that you adhere to, then you are on the right path to success.

With every trade you undertake in the stock market you are opening yourself up to risk and 'you' are the only person that can control this. The key to controlling risk in the market is to use some simple money management techniques that aim to protect your trading capital and quantify your risk. You need to consider the following in your plan:

• What type of instrument and time frame are you prepared to trade in the market? This depends on what instrument you choose to trade, such as shares, options or futures, as well as the liquidity of the chosen instrument. Some instruments are more volatile and shorter term in nature than others, which gives them higher risk profiles. You need to select one that suits your personality and style of trading.
• How much risk are you prepared to take on each trade? Position sizing is a money management tool you can use to control this and determine how many shares you can buy based on the percentage risk that you are prepared to undertake on any one trade.
• How will you limit your losses and protect your open profits once in a trade? Stop losses are your key to survival when entering a trade and allow you to protect your open profits once the trade moves your way.
• When should you add more money to an existing trade? Successful traders use a technique called pyramiding to add to profitable trades.
• What is the maximum position size you will take on any one position? You want to ensure that you are not putting all of your money into one trade, because if that trade fails, then your chances of success are a lot lower than having your capital spread between multiple positions. As a general rule it is best to ensure that the maximum size of a position (including pyramiding) does not exceed 25% of your total equity.
• How will you manage your total open market risk? Portfolio heat is a method used to manage your overall risk in the market at any one time. So if all your trades were to hit their stops tomorrow, you know up front your worst case loss. For more information on portfolio heat, click here.

Getting back to the golden rule of trading. It does not matter how many winning trades you have, if you can't manage to keep your profitable trades larger than your losses you will not survive in the market. You only need to have one or two bad trades in your portfolio that you let go (such as a Onetel or HIH), and do not exit at a small loss, and your entire portfolio could be in a losing situation. There is no such thing as hanging on to a losing trade in hope. You may have heard it from someone else or said it yourself - "don't worry the share will come good again and I will get my money back". Then again maybe it won't!