Most of the time the excitement is in choosing stocks to buy, even choosing specific price ranges to make the buy. However, buying is only half of share trading. The other half is of course Selling.
Selling is where most people get it wrong. What is called Risk Management in formal finance literature is tied to both buying and selling. However even those people with a willing sell strategy often get it wrong.
This article outlines one of many techniques of Risk Management all the way through from buying to selling. It is true that a good trade should know when to sell even before it is bought.
1. Starting from a fixed capital, say $10,000; decide that each trade should not lose more than 1%. This lets you lose 100 times before you are totally bankrupt.
So amount of each loss is 1% of $10,000 = $100
2. Determine an entry price $x. There are many ways to determine this buy price and will not be covered here. Suffice to say that let buy price = x
3. Determine the exit price $y. This is done before even buying the stock. Various ways of determining this is by
i) %Loss of Entry, say tolerate about 5% loss of buying price.
ii) Using price patterns in technical analysis, such as ABC pattern, or looking at previous support / resistance levels.
4. THIS IS THE KEY. Calculate number of shares to purchase N.
So N = Loss / (x-y) = 100 / (x-y)
Most people including myself buy a fix number of shares, based on what size of investment we can afford. Eg. Want to spend $1000, and the share price is $50, there choose to buy N = 20 shares. This is the wrong way to do it.
5. Finally after calculating N, the initial investment can be determined. So the initial investment is the units times entry price = N * x
There is nothing to worry about the investment being too big. True, $x can be any value. However, the calculated N has already taken into account the tolerable loss (x - y), so the N would ensure the size of investment is reasonable.
These steps contain the decisions for good risk management. The size of the investment must NOT be a decision - that needs to be calculated.
Posts
