Are You Ready to Trade Stocks? Part 3: Avoid Risk to Get to the Top

The third of a three part series about getting ready to trade stocks.

The top of trading is the best
Get to the top by avoiding risk.

Today's article is the third of three in a series by guest author Adrian Reid, private trader and founder of Trading System Life. You can also follow him on Twitter @TradingSysLife

What do risk and money management rules do?

Simply put, risk and money management rules stop you from losing all your money so that you can trade for long enough to actually make money from your trading system.

If you risk too much on each trade then a short string of losses will wipe you out or at least put a big hole in your account.

But if you risk too little then you will not make enough profit to bother going to all the effort.

Many people out there will tell you that you should risk 2% or 5% of your account on each trade. My experience has shown me that even 2% is generally far too aggressive for most traders and most trading systems.

When constructing your risk management rules consider this - most stocks in the market are highly correlated. This means that if the market changes direction, so do most of the stocks in the market. So if you have 10 positions and you are risking 5% on each one and the market suddenly changes direction, you could lose 50% of your account if they all get stopped out!

Backtesting different levels of risk per trade is critical if you are going to meet your trading objectives - particularly drawdowns! When you simulate your portfolio in something like TradingBlox or MultiCharts (or any other trading software that does portfolio level simulation) you will probably find that the ideal risk level is much lower than you think.

For example, I risk less than 1% of my account on each trade.

Also, remember that the optimal historical risk per trade could be too aggressive if things change in the future, so you should probably select a lower risk than the historical optimum.

Why do I need to write it all down in a trading plan?

Unless you have a complete, written trading plan before you start trading then you are putting yourself in financial danger.

I believe everyone who is trading should have a written trading plan before they start trading to guide their decisions. This has several key benefits:

1. Reduces the need for spontaneous judgement

2. Reduces the impact of emotions

3. Ensures you treat your trading like a business

Businesses without business plans fail, so do traders without a trading plan!

A good trading plan will cover just about any situation you come across. When you write your plan you are effectively pre-defining what you will do in each different situation the stock market throws at you. This works because you are making these decisions when you are calm and stress levels are low. Humans do not make good financial decisions under stress, and so deciding anything in real time when the markets are moving heavily against you creates a high risk of trading mistakes and losses.

Conclusion

So are you ready to trade stocks?

It takes a little more than what most new traders might think, but the effort required to write your trading goals, find profitable trading systems, put sensible risk management rules in place and write your trading plan will pay off in the long run. This really is a path to a fantastic financial future and perfect lifestyle…if you prepare yourself properly!

A consistently profitable trading account can transform your financial future and your life. So do the work to get ready to trade stocks profitably - I guarantee you will not regret it.

Photo Credits:    Echo/Cultura/Getty Images