A Day Trader's Guide To Risk Management

I chat with many novice day traders every day, and the area that I consistently find new traders struggle with is understanding and adopting effective ways to manage risk. While many of these green traders have a solid surface-level understanding of risk management — the idea that having contingencies in place will limit their potential trading losses — there is a big disconnect when it comes to actually putting risk management strategies into practice.

While applying risk management to your trades can seem arduous when you’re first starting out, the sooner you get used to it, the sooner it’ll pay off.

Know Your Ratio

The most fundamental aspect of introducing risk management into your trading strategy is actually understanding your risk tolerance. Figuring out how much risk you’re comfortable with means formulating a profit/loss ratio, which is what you expect to profit versus what you stand to lose on a given trade.

For example, say a stock trading at $5 has shown indications of moving to $7 and you are thinking of purchasing 100 shares for a $200 profit. If you are willing to hold that stock until the point that it either reaches $7 or it falls to $4, a $100 loss, your risk/reward ratio is 2:1. This means that you’re willing to lose half as much as you hope to gain in that position.

Your ratio will vary based on your strategy, the size of your position, the type of stocks you trade, and other factors. While the ratio may be fluid over time, new traders need to continuously work toward assessing their desired level of risk. The more frequently you identify where your risk tolerance is, the quicker you will be able to identify which trades fall within your ratio and meet your criteria.

Plan Your Entry And Exit Points

Part of understanding your risk tolerance is knowing exactly where your price points lie in each position you take. This means identifying several things, mainly: a stock's fair value, your entry point, and the levels at which you will either take profit or cut your losses. Stop-limit orders, will help in the latter case, but you shouldn’t rely on stops alone. There is no substitute for trading discipline.

Consistently reassessing your risk/reward ratio will help you develop discipline. But defining those prices before entering a position will also keep you honest and help you avoid making a rash decision and completely tanking your strategy.

Cap Your Losses And Stick To Your Profit Goals

When you are actually in a trade, whether it’s going your way or not, you absolutely need to stick with your stated trading plan. I say this knowing full well that this is easier said than done.

In the case of a losing position, capping your loss at your stated target will prevent you from falling into one of the most common traps among even experienced traders: averaging down. Averaging down means buying more shares of a stock at a lower price in hopes that you will more easily recoup your losses if the stock turns around. Forgoing your loss cap is basically a manifestation of the sunk cost fallacy, and will inevitably lead to a negative record over the long run.

The risk involved in holding a winning position past your profit taking point is a little less obvious. While the appeal of promising momentum in a stock can net you a few extra dollars, you should trust the due diligence you put in before entering a position. The longer you hold on to a position passed your original itme horizon, the greater the chance you'll give back your gains. 

In short: take profits when you get them.

Journal Your Trades

Finally, following every trade you make, record your thought process behind each of these steps as well as the outcome of the trade. More than anything else, having a consistent and concrete log of your trading history will prove an invaluable resource in modifying and refining your strategy.

With a well-maintained journal of your trading, you should see not only how effective your risk-management strategies have been and whether you might need to alter course, but also revisit how your trading, income or savings goals have changed over your tenure and modify your approach from those facts.