New Traders, Risk Management, and Position Size

Risk management is probably the most important thing a trader needs to practice. Whatever size position you think you should get, cut it by 50% or more. Beginners tend to take positions that are several times the size they should be or place stops much too far away. The risk of loss for each position should represent no more than 1% or 2% of your portfolio. We favor a maximum risk of about 1%.

If you are a beginner and you have $20,000 to invest, it would be a big mistake to divide the money into four parts with $5000 in each part. Your portfolio could fall far too much because of the decline of a single stock. An experienced trader would know how to deal with the increased risk, but it would be rare for a beginner to deal with it correctly.

A person is likely, as a beginner, to make more investment mistakes than he ever will again. Why, during the riskiest part of your learning experience, would you want to increase that risk unnecessarily? Since your trades are most likely to lose money in the beginning, strictly limit the size of each position. Because most beginners do not have a good understanding of support and resistance levels yet, they are more likely to buy well above support. Therefore, the stock can decline all the way down to its next support level without there being a rational basis for selling. If, however, the stock were purchased right at or slightly above support and it declined below that support, there would be a very good rationale for selling. The beginner tends to be sloppier about his entry points. That automatically increases the risk inherent in a position.

The typical beginner places his stop losses 10% or more below his purchase price. Because of a fear that the stop might be triggered, some will place the stop at 20% or more, almost eliminating the purposes for having a stop loss. The market does not know where the stock was purchased, so using the purchase price as a basis for placing a stop loss is one of the least meaningful approaches that a person can use. From the market’s perspective, such a stop has no relationship to the forces of supply and demand that have defined the stock’s chart pattern.

If the individual buys a stock at $50 a share and uses a quarter of his assets to make the purchase, then a drop in stock price that is sufficient to trigger a 10% stop loss would make a 2.5% impact on the portfolio. That size of a loss is simply too much. For a portfolio worth about $20,000, no single position should be capable of causing more than $200 in damage. Therefore, in the case of a $20,000 portfolio divided into four investment of $5,000 each, the stop loss should be no further away from the purchase price than about 4%. That can work only if the purchase price is right at support. That way, the stock’s entire decline is significant. However, if the stock is bought 3% above support, then a decline of 3% does not mean anything other than that you have lost 3%. In other words, you have to have a decline of 7% in order to have a 4% penetration of support. The first thing our own stockdisciplines.com traders do when considering a trade, is determine where the stop loss should be placed. If the stock has to drop too far (based on the size of the position) in order to trigger that stop, then the trader abandons the idea.

If the beginner divides his money into ten portions, then he would have only $2000 in each position rather than $5000 as in the above illustration and his risk would be much less. Then he could set his stop loss at 10% and if the stop loss is triggered he would lose only $200 or 1% of his portfolio.

It is extremely important for a new trader/investor to start with only a portion of his investment capital. He should buy near support so that a decline below the purchase price has meaning, and he should set his stop losses so that no position can inflict more than a 1% loss for the entire portfolio.