No matter how much investment research is done or how selective we are, many of our trades will be losers. It is for this reason that we need to control risk on every trade. Unfortunately, we don't automatically know if it is going to be a winner or loser (otherwise, we would always avoid losers). A loss can easily get out of hand if not controlled. Volatile stocks can erase a significant portion of a trading account in minutes, especially if leveraged. To avoid this, cap the risk on each trade. Here's how to do it:
- As a general rule of thumb, many traders don't risk more than 1% or 2% of their capital on any given trade.
- Traders must have the discipline to exit trades when their maximum allowable loss has been reached.
- It's a good idea to use a conservative risk limit because you never know when a trade will unexpectedly move against you, and you may occasionally lose more than you planned on risking.
How Much Capital to Risk on Each Trade
How much capital you risk depends on your account size, but as a general rule, don't risk more than 1% of your account on a trade. In other words, don't lose more than 1% of your trading account on a single trade.
If you have a $30,000 account, you can lose up to $300 per trade; however, you can still utilize all of your capital. For example, if you buy 1,000 shares of a $29 stock, you have used up most ($29,000/$30,000) of your buying power. As long as you don't lose more than $300, your risk is less than 1%.
Many new traders think that risking 1% means they can only utilize 1% of their capital in a trade; that's not true. Most day traders use a significant portion of their capital and sometimes more than what they have (via leverage) on every trade.
Trade Risk Variations
Some traders are willing to risk up to 2% of their account. This is typical if the account is smaller and the trader is willing to risk more to make more. In the stock market, you are required to have $25,000 for day trading (there are a few alternatives); if you risk 1%, you can lose up to $250 on a trade, which should be more than enough. If risking 2%, you can lose up to $500.
With a large account, set a fixed dollar risk of less than 1%. For example, if you have a $500,000 account, you can risk up to $5,000 per trade. However, it is not required that you risk 1%. If that is more than what you need, choose a smaller percentage. Risking $1,000 or even $100 per trade can provide an excellent living. As long as you are earning an income you are happy with, that's all that matters. Don't assume more risk than desired.
Making Sure Your Trades Don't Exceed the Risk Limit
Now you know how much you should risk per trade based on your account size. For most stock market day traders, risking 1% or less is ideal.
It is important to adhere to that risk limit. If you have a $30,000 account, you can risk $300. The easiest way to make sure you don't lose more than $300 is to use a stop-loss order. A stop-loss order gets you out of a trade when the price moves against you and reaches a preset price.
For example, let's say you buy a stock at $14. It looks like it could rally to $14.50 but may fluctuate a bit before it does. The price recently bounced off of $13.80. As a result, you place a stop loss just below this small support level at $13.78. The distance between your entry price and stop loss is $0.22.
Remember, you can risk up to $300. To determine how many shares you can buy, divide $300 by $0.22 (1,363 shares). If you buy 1,363 shares (round down to 1,300 ideally) and lose $0.22 on those shares, you've lost $299.86, which is pretty close to your maximum loss of $300.
Buying those shares costs $14 x 1,363 = $19,082. A significant portion of the available funds was used to make the trade, yet less than 1% is at risk.
Risking 1% or less is also a good idea because occasionally we'll end up losing more than we bargained for. While we set a stop-loss order, we could incur slippage, resulting in a loss of more than 1%. Typically, slippage is minimal, assuming you avoid trading around major news events and trading stocks with high volume.
Final Word on Trade Risk
If you open an account with more than the required $25,000 for day trading stocks, risking 1% per trade is sufficient. Assuming you win about 50% of your trades (or more) and can make 1.5% to 2% on your winners and keep your losses to 1% or less (of account capital), you'll make a good income. This may sound easy, but it requires a solid and well-practiced method for day trading stocks.
Risking 2% is unnecessary, and it is the most a stock trader should risk on a single trade. Occasionally, we will end up taking a bigger loss than we expect; so the smaller the original risk, the better. To properly cap your risk, set a stop-loss limit, and then calculate how many shares you can acquire to keep risk below 1%. In this way, each trade is perfectly calibrated to the trade and account size. Risk is controlled, yet it still allows for a good income.