Many people aspire to make a sustainable living from stock trading. However, the failure rate of these individuals is well over 90%. There are many reasons for these failures, but most have one common theme: the lack of objectivity in trading methods. Subjectivity in trading is one of the most dangerous mistakes than can jeopardize a trader's ability to succeed in the market, or to continue as a trader.
Over the years, I have heard many stock traders refer to the ?double down? theory ? the concept of investing more money as a stock falls on the hope that the stock will rise, to make up for lost investment capital. This approach very often results in throwing good money after bad, because as the stock continues to retreat, most traders get nervous at this decline, and sell at a low.
Every trader has to deal with losing trades. Even the best traders will have streaks of losers. To overcome this, and limit your losses, you must deploy objective methods in your trading. First, every stock trade you place should have a predefined stop-loss, as well as a predefined exit strategy. But keep your attention on how much you can lose. By doing this, you can quickly exit your losing trades without emotion, and redeploy capital to potentially winning trades.
The number one rule of trading is to preserve enough capital to continue trading. However, a common mistake made by new traders is buying or selling too many shares, or placing a bet that is too large. Consider this: if you lose 30% of your trading capital, you require a 43% return to break even again.
One method deployed by professional or full time traders is referred to as money management, risk management, or position sizing. This concept helps a trader determine how many shares of a stock to purchase or sell. This concept is closely related to diversification, but in a much more quantitative manner. In evaluating a trade, successful traders will risk no more than 2% of their portfolio value, and will only buy or short as many shares as that allows. For example, if your portfolio value is $10,000, your risk capital is $200. If your stop-loss on the trade is $1.00, then you can buy 200 shares.
As you can see, these are just a couple of the major obstacles that traders face. However, by managing risk through objective, quantitative money management techniques, you can overcome these issues and greatly improve your chances of being a successful trader.
Ben Dooley is Managing Director of SophiVest, LLC, a provider of advanced
money management and
market simulation tools. He is also a full-time trader and holds a BS in Engineering and MS in Finance.
