Day Trading Risks: Trade Risk and Losing Money
Discussing What Most People Think of When They Think of Risk
Ask someone what day trading risks there are, and likely one of the first answers out of their mouth will be "Losing money." It's the primary risk people wish to avoid when they start day trading. Learn how to control losing money below.
There are actually multiple types of risk which will be covered in this "Day Trading Risks" series. Losing money is the big one, though; most of the other risks contribute to losing money, so losing money--trade risk--must be tackled first.
Even the best traders lose on many of the trades they take. Losing 40% to 60% of the trades taken is common, and can still result in a winning trading system if the trader makes more on winners than they lose on losers.
Losing money is actually inevitable. It will happen. The real risk is a string of losses (or a few very big losses), which can ultimately drive the account to zero, or almost zero. While losing money on any given trade is inevitable, losing everything in the account isn't.
Consistently profitable traders have many losing trades, but still don't lose much of the money in their accounts...and on top of it, are profitable at the end of each month! How do they do that?
Monitor Trade Risk
One key factor to consistent day trading and limiting losses is managing trade-risk. As discussed above, any single trade can lose, no matter how convinced we are that it's a winner. For this reason, the risk on every single trade must be capped.
One of the easiest ways to cap trade risk is to use a percentage of your day trading account. For example, limit any single loss to 1% of your account capital. If trading a $30,000 account, the most you can lose on a trade is $300. (To see how much capital you need for day trading, see Capital Requirements for Stocks, Forex, or Futures.)
Just knowing you can lose $300 on a trade won't help you develop consistency. Take it a step further.
Factor Trade Risk on Every Trade
Some traders may see the 1% rule, agree with it, then proceed to implement it in this way:
- See a stock they like. Buy 2000 shares of it at $12.65, and tell themselves that if the position reaches a $300 loss they will exit.
This approach is incomplete. Before taking a trade look at what price a stop loss order should be placed at on the trade. In day trading--because the market moves so quickly--an actual stop loss order isn't always required, but know at what price you will exit the trade if it goes against you. The market often moves around before it moves in your favor, so the stop loss price is the price which tells you are wrong about the trade, at least for now.
With this in mind, our trader decides she will buy at $12.65 and place a stop loss at $12.57. She is taking on $0.08 of risk for every share she purchases.
She knows she can lose up to $300, so divide $300 by the risk per share on the trade: $300 / $0.08 = 3,750. That's how many shares she can take given the $0.08 risk per share, and the $300 maximum trade loss she is allowed.
This is a much more detailed approached and requires a bit more planning.
Planning ahead for possible contingencies is an important skill for day traders.
Taking the position also requires planning in other ways. Will the stock allow for a position size of 3,750 shares? If the stock is thinly traded (not much volume) trading 3,750 shares on one trade may not even be possible (see What to Look For In a Day Trading Stock). Also note that this trade requires leverage. To buy 3,750 shares at $12.65 costs $47,437.50, but our trader only has $30,000. Getting leverage of up to 4:1 is common in stock trading, and leverage up to 50:1 is common in forex trading.
Your risk is now defined, you shouldn't lose more than 1% of your account on any single trade. Losing 40% to 60% of your trades isn't uncommon, though, so if losing about 50% of your trades your winning trades need to be bigger than your losing trades.
This is where the reward-to-risk ratio comes in.
Based on the chart you are looking at, does the trade provide you with a reasonable chance to make more on a winner than you'll lose on a losing trade? Ideally, your profit potential should be 1.5 to 3 times your risk. So if you are risking $300, the trade should give you a reasonable opportunity to make $450 or more. If it doesn't, walk away.
Bringing It All Together
Losing money on individual trades will happen a lot; expect to lose about 50% of the time. But you can still be profitable. Keep risk on each trade to less than 1%, that way even a string losses won't significantly draw down your capital. For example, if you lose 10 in a row, you still have 90% of your capital intact, and a few winning trades will recoup that.
Assuming you'll lose about 50% of your trades (some traders may be lower or higher), profitability requires winners to be bigger than losers. Strive to make 1.5 to 3 times as much on your winners as you lose on your losers. Even with losing about half of the trades taken, and only making 1.5 times as much on a winner (losing 1% and making 1.5% on winners), the result at the end of the month can produce a great income (see How Much Money Stock Day Traders Make).