Chart courtesy of Stock Charts.com

The following is an article from Dr. Timothy Morge, a vetran institutional trader, money manager, and trading educator. The essentials of limiting and controlling risk while trading and investing are explained eloquently in his below comments. If this sounds familiar as you read it is because it is if you have been following this column. The more you search around for the answers to your trading quesitons you will find this topic at the core of your findings. In fact, if you trade and you do no t have a money managemnt system it is likely you will not last. The following is very detailed but it aids to understand. More ore about Dr. Morge and his trading can be found on Marketgeometry.com.

When you begin stalking a trade in a particular market. you may want to consider calculating the risk of the trade. One way to do this is to calculate equivalent risk units and use that to determine your position size. Some traders choose to buy a standard number of shares, or use total cost to determine their trade size. But it’s a good idea to normalize your trade size by maximum risk, meaning you should risk the same maximum amount on each trade you enter. That way, if your trades don’t go your way, you will be able to anticipate the size of the losses and plan your overall strategy accordingly.

So how do you figure out the same risk level across different stocks. You can work out equivalent risk units using an Excel spreadsheet and the normal and abnormal volatility of any instrument you are going to trade, along with the current price. Once you tie each instrument together on a spreadsheet, you can set the maximum amount you are willing to risk on any single trade; based on your inputs, the spreadsheet will then tell you how much of each instrument you should trade at the maximum amount of money you are willing to risk.

Dr. Timothy Morge

This spreadsheet shows the difference between always trading 10,000 shares of stocks versus trading sizes that exposed your portfolio to similar or equivalent risk. To find equivalent risk, this example began by using 10,000 shares of Apple Computers at its Average True Range (ATR). ATR looks at the average size of the range between the days high and low, or the high or low compared to the previous days close (whichever is greater). Typically the measure averages across 14 days, though some traders modify the time periods for their own customization. ATR gives me a measure of how large the average size of a daily range is in Apple [including overnight gaps].

Using simple math, work backward, so that if I took a position in the ETP GLD, which reflects the price of Gold, I would be exposing my account to a similar risk, based on the average true range of GLD and the size of the maximum stop loss I apply when trading GLD. In this example, if I was trading 10,000 shares of Apple, an equivalent risk would be reached if I traded 25,000 shares of GLD [instead of 10,000 shares]. Thats quite a difference.

Why is equivalent risk important? To be consistently profitable, you need to make more on your winners than you lose on the trades that dont work out. Using equivalent risk lets you normalize the size of your losses. Once you know how much you might lose, you can evaluate potential trades with an eye towards consistent profits (see the section below on evaluating the risk/reward profile of a trade).

One last thought about risk units and the amount you are willing to risk each time you take a trade: I personally limit the maximum risk I’m willing to take on any one trade to about 1 % to 2% of the total capital in my trading account. I want to always risk a relatively small portion of my trading capital. That way, if I experience a string of three or four losses in a row, it will not greatly damage the value of my trading account. Especially when you’re learning to trade with a relatively small trading account, for example account of $10,000, smaller risks can help minimize the overall impact that losses will have on your total capital. Controlling your position size will help your balance survive while you attempt to become a consistently successful.

Before you enter a trade, take the time to write down your plan. Writing your plan down will help ensure you have thought it through, and reduce the potential for emotions to cloud your judgment. Here are a few elements to include.

Decide upon an entry where you will open a long or short position.

Decide where your initial stop loss will be placed on this particular trade. One idea: Consider placing a stop loss order above swing highs or below swing lows, rather than simply placing them at a fixed cash distance from the entry. That will help to customize your trade based on the volatility of the specific instrument you are trading. People define swing lows and highs differently, but you can choose an appropriate period for your trading strategy, which could be days or weeks, and use the highest high and lowest low. If you find that the size of the initial stop loss order is larger than the maximum amount you calculated in your spreadsheet, pass on the trade. You can continue to watch, in case a better initial stop loss opportunity presents itself, but never risk more than your maximum risk unit amount on any given trade.

Dr. Tomoth Morge

You can see that price began a strong uptrend about halfway through this chart. If you managed to catch a long entry early on in this move, you’ll want to let your profits run as long as possible, yet still protect profits as price moves in your favor. As price makes higher highs and then pulls back to form higher lows [the definition of a market trending higher], wait for price to make another higher high, and then move your initial stop loss up, just below the newly formed higher swing low. As other traders realize price is trending higher, they’ll want to get on board the trend, so they will leave new limit buy entry orders at or near these new swing lows. Since you are already long at better levels, you can hide your stop profit order just below the levels where these new limit buy orders are resting and gain important protection from the new limit buy orders. And if price pulls back again and then goes back higher to make another new high, leaving a new higher swing low, you can move your stop profit up under the newly formed higher swing low, boxing in more profits. Keep using these swing lows, and the new limit buy orders that will likely build up there, until you either hit your profit target or until your profit stop is hit.

Setting profit targets

If you have an acceptable initial stop loss, you must have a totally realistic answer to this question: What is the minimum profit potential for this position if it begins to move in your favor? To answer this, you have to consider things like prior swing highs, simple trend lines that other traders will be considering, the areas where larger traders may have left limit buy or sell entry ordersin short, what difficulties might this position run into, and how will I deal with them as it moves further in my favor?

Exit strategy

The last question is related to each trader’s style: Am I going to try to scale out of this position at various levels or try to exit the entire position at one profit target? If I am going to take partial profits at various levels, I note these levels at this point. I almost always enter my entire position at one level and exit entirely at the profit target if price went in my directionbut that’s my own style; yours may vary. The important thing is to plan out your actions now, before the trade, so the thoughts behind the trade can be analyzed.

(Editors note: Choosing to scale into or out of a position may create increased commissions.)

Choosing trades using risk and reward

Now we are ready to calculate a potential risk-reward ratio. Let’s assume that we want to buy 1,000 shares of Ford Motor Co. stock at $7.09 per share. Our initial stop loss on this position will be $.25 below the prior swing low of $6.61, at $6.36. Our profit target will be $8.83 per share, $.05 below a test of the prior major swing high at $8.88 per share. We are risking $.25 to make a potential $1.74 per share. The potential profit of $1.74 per share divided by the initial risk of $.25 equals a risk reward ratio of 3.48 to 1. Once you begin to work with risk-reward ratios that are higher than 2 to 1, you may see the consistency of your trading improved dramatically.

Lower risk-reward ratios, for example, risk-reward ratios under 1 to 1, mean that you have to maintain a very high winning percentage to remain profitable. Lets look at a hypothetical example. Lets say you make 10 trades in a month and your winning percentage is 33% and your risk ratio is 0.8:1. You begin with a $25,000 account and your maximum acceptable risk is $250 per trade. In this example, you would have made 3.3 winning trades and each winning trade would be worth 80% of $250, giving you positive income of $660. On the other hand you would have made 6.7 losing trades, and each losing trade would be worth 100% of your maximum risk: a loss of $250. For the month, that gives you a negative income of $1,650. You would only be profitable one-third of the time and your winners would only be worth 80% of the value of your losers. You can see this is a recipe for disaster: The result of your 10 trades would be a net loss of $990, or a roughly 4% decrease of your account’s value at the beginning of the month. (Note: This hypothetical does not reflect trading commissions or other fees.)

The other side of this situation might look like this: Beginning with the $25,000 account at a maximum risk per trade of $250, you make 10 trades in a month and 33% are profitable. Your risk-reward this time is 4 to 1. Things look much better now: You made 3.3 winning trades, and each winning trade would be worth four times your $250 maximum allowable risk, giving you a positive income of $1,000 per trade and resulting in a positive income of $3,300 for the month. You still would have made 6.7 losing trades and each losing trade would be worth the $250 maximum allowable risk you set for yourself, giving you a negative income of $1,650 for the month. Even with the same winning percentage, you would have moved from a loss of almost $1,000 to a gain of $1,650. That shows the importance of calculating your risk-reward ratio and choosing trades that put you in a position to be consistently profitable.

The bottom line

The simple truth is that your ability to understand and master money management and its various components will likely determine whether you will become a successful trader or whether you will quickly drain the capital out of your trading account. Take your time investigating and learning about money management before experiencing large losses trading. You will save yourself not only a great deal of money, but you will also prepare yourself a solid foundation upon which to become a consistently profitable trader.