Risk Management For Technical Trading And Investing



Step 5: Risk Management

Trading in the Stock Market can result in rich rewards but it is also froth with a great degree of risk.

To navigate the shark infested waters that is the Stock Market, a rigorous Risk Management strategy is needed.

Trading and investing should not be left to chance. Risk Management is absolutely necessity in order to be successful.

There are several tools that can be used to aid in effective Risk Management. Some are more successful than others. Some also cost more than others.

Listed below are some of the more effective ones. Two of them have already been mentioned in an earlier prelude of this series.

One Not Mentioned Is Diversification

Diversification is a key tool in risk management. Limit the size of any position to no more than 5% of your portfolio.

Even though you get wiped out completely in that position, the effect on your portfolio will be minimal.

Diversification shouldn’t only involve the number of stocks you have in your portfolio. It should include different sectors and countries as well.

Diversification should include US and Global stocks as wells as ETFS.

Another Risk Management Tool Is Options

Options can be used for flat out speculation, as a trading vehicle or as an investment hedge.

When you use it as a hedge, you would buy the stock and an accompanying Put.

Alternatively, you can buy the stock and sell a Covered Call.

Both of these strategies, buying a Put or selling a Covered Call, have their advantages and disadvantages.

The advantage of buying the Put is if the stock loses value, the Put Option will be gaining in value to substantially compensate for the loss of the stock’s value regardless of how far the stock falls.

One disadvantage, and it’s a small one, is if the stock increases in value, you lose in the value of the Put Option, but your lost is limited to how much you paid for the Put Option.

Another disadvantage is if the stock price goes nowhere after buying it, the Option loses value as time passes.

With a Covered Call on the other hand, if the stock price goes nowhere after buying it, you still will make money on the Covered Call. Remember you sold it and as the price decreases that is to your advantage.

The Covered Call also affords some limited protection if the stock moves down, but it’s protection is limited roughly to the price of the Option. If the stock pulls back beyond that, you are not protected.

Also, when you sell Covered Calls, you limit you upside gains because as much as you gain in the price of the stock you will be losing with the Option.

It is important to note that when you buy an Option, your gain is limitless (in the case of a Put, it can gain as the stock price pulls back all the way to zero) but a Call is limitless.

Well at least that’s the theory, but we know that stock prices do not go all the way to the moon and gravity will catch up sooner or later.

Remember, this is not a lesson about Options and any mention of them is cursory and limited to the scope of these writings.

Another Risk Management strategy is the use of Stop Orders

This will automatically close you out of your position if the stock or option price gets to your predetermined price. Don’t set your stops too close to the actual trading price. If you do, regular market gyrations will cause you stops to be hit and close you out even when a solid uptrend is still intact.

The big disadvantage is that markets do close at the end of the day. At the start of the next trading session, there is no telling where the price will start.

They usually start where they close the previous day but at times they can gap up or down especially if there was some market moving news overnight or some news that is unique to that particular stock.

Gapping can happen during trading hours also for the same market or stock moving news, but this is a rarity.

In any case, if you implemented prudent risk management, and the very worse happens, say you get wiped out of an entire position, which should never happen if you did your due diligence before going in, the worse that should happen is that no more than 5% of your portfolio would be in jeopardy.

So you understand the risk. Understand also that you will get hit from time to time regardless of how well you designed your strategy and followed your entry and exit rules.

However, if ever or whenever you get burnt, prudent risk management will mitigate the damage.

With that full understanding, stocks still should be the biggest part of your portfolio allocation. Up to 60 - 80% of your portfolio should be in stocks, then the remainder in cash and a lesser part in options, if any at all. Your Option holding will depend primarily on your risk tolerance.

You want to have sufficient cash to take advantage of the next opportunity that is always presenting itself.

Also the younger you are the greater stock exposure you may want to adopt and also the more risks you can tolerate. You have more time to regain from bad things happening.

All the same, your preparation and adherence to your trading strategy and rules should not be neglected. The only difference is that you can build in more aggressive plays in your strategy. You don’t have to, but it’s a choice.

Again, even when you do, all the rules apply!

You are almost done!

Step 6: Finally, You Have To Set Up Some Routines

  • Daily Routine.
        Check current positions and look to:

      1. Tighten Stop losses unless your brokerage has Trailing Stop Loss when you place your order to exit.

      2. Add to current positions

        Look at your watch list for Set-Up’s and Triggers

      1. Set-Ups = stock setting up to give you an entry signal in the next few days.

      2. Trigger = The actual buy signal

        Continuing Education

      1. Read and study.

      2. Listening to market news channels can be good but you must be able to filter out the noise.

        From them, you get fast braking financial news quickly and at times good analyses but the 24/hr per day coverage behooves the need to keep things interesting and that leads to the noise.

        The noise is not at all helpful and at times downright hurtful. Remember their objective is ratings.

        As such, their use of Attention Getters and Hype can also lead to emotional decisions as some things are just set to play on your emotions.

  • Weekly Routine

        Risk and Diversification Analysis

      1. Is your overall portfolio diversified?

      2. What sectors and countries are you invested in?

      3. Review your trading journal and spreadsheet

        Do Market and Sector Analysis

      1. What are the long, intermediate, short term trends in the Global markets?

      2. What sectors are leading the markets?

      3. What areas of the globe are outperforming others?

        Searching for Opportunities

      1. Look at the holdings of the ETF’s that you track to find stocks within.


      1. Continue to educate yourself for the week to come.

What about Tax Consequences? You only have that problem if you are making money. What a nice problem to have. It’s a problem you aspire to have! At that point, consult with your CPA.

Further Reminders:

  • Do not put more than 5% in a single position. As you get more proficient, you can make some adjustment to this. For now do not violate!

  • When a stock is bullish, even though you get a sell signal, do not initiate a short position unless it signals a reversal (you may also be using a software that gives Buy an Sell signals). Not every trend violation signals a reversal.

    In fact, if you are just starting out, make it simple for yourself and just trade on breakouts.

  • Also, your time horizon is important when you are trading options.

  • You must have your trading strategy written out and handy - ALWAYS - and refer to it before placing your trades. You want to follow it to the letter until it becomes second nature.

Additional Tangential But Helpful Information

You want to make a spreadsheet that tells you at a glance what is going on. Excel is ideal but if you don’t have it, any other spreadsheet will do.

On it you will list the date, price, number of shares or contracts in the case of options. You should also have the exit price. Your GTC (Good Till Cancel) order should also be already placed.

Also, monitor to make sure that your are adhering to your strategy and to constantly find new opportunities.

That’s it for now!

Thanks for your attention.


I have tried to present this in as a straight and as an unadulterated form as I am able to.

I hope this effort is helpful. These are roads that I myself have traveled. I have taken my fair share of blows. Some of the pitfalls I have learnt from the hard way.

My intent is to guide where ever and whom ever I can who are traversing these same terrains so that they can avoid those same pitfalls and benefit immensely at the same time.

The Stock Market is a gold mine of opportunities but it is also a mine-field of dangerous zones.

With a disciplined approach, you can take advantage of the multitudes of opportunities, while avoiding the danger zones.

Yes, with a disciplined approach, you can benefit immeasurably - the sky is the limit.

Coming are loads of good information, stay with us and continue to check often. You should even sign up for our E-zine for important updates.

Please give some feedback as to the contents of this article. Actually, it is a series. If you missed those before, make sure you follow the links back to the previous ones.

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