Money management is a critical part of any successful trading strategy and one area that is easily over looked. In essence, there are three basic calculations that you should be making prior to entering a trade and should form part of your trading plan.

1. How much of your total portfolio will be used to enter a trade. For the purchase of regular blue chip shares, I would suggest between 10-20% no more. If trading CFDs Options etc, you may want to lower this figure to 5-10%

2. What is that maximum you are prepared to loose on this trade, if it goes bad? This is where your stop loss will be used. I would recommend not risking any more than 10-15% of the amount that you have invested.

3. If you were to get stopped out; how much of your total portfolio would you loose?

For example if you have $10,000 in your trading account. You use $2000 to enter a trade (20%), you set a stop loss 10% below your buy price. The maximum that you could loose would be $200 or 2% of your total account which is acceptable. It is best to keep this figure within 1 to 3%.

Stop Losses

If you are to become a successful share trader, it is imperative that you develop robust risk management strategies which enable you to cut your losses short, should the trade go against you. Part of your strategy should always be using Stop Losses.

A stop loss is a price point where a trader will sell a security once a certain price has been reached. So as the name suggests, stop losses are there to limit an investor’s loss on a stock position. Basically, a stop loss is used to either preserve capital when a recently entered trade has turned against you or to protect your profits in a winning trade.

Stop Loss to Preserve Capital

This is where it is easy to make a mistake because the stop loss you place will be dependant on the market and instrument you are trading and whether you are using leverage to trade with. For example, the stop loss you might use to trade blue chip shares would likely be different to one you place on a speculative stock due to volatility.

Also, if you are using leverage to trade, a 10% move in a stock could equal to a move of 100% or more in an options or CFD trade. So, it is essential that when setting your stop loss you understand the market you are trading.

Before you make the decision to enter a trade, you should know (using your trading plan) what the maximum capital you are prepared to risk and set you stop loss accordingly.

How to set a Stop Loss?

When setting your stop loss you need to be close enough to the buy price so that you do not lose more than 1% to 3% of your total capital (although, if you are starting with a small trading account, exceeding this level may be unavoidable) but far enough away so that the stock has room to move in case it falls briefly after you buy into it.

When setting a stop loss on regular Blue Chip shares; you can either set it as a percentage of the buy price or at a price point. In your trading plan, it is best to work out both stop losses, and then use the one that gives you the least amount of loss.

For example: You want to buy ABC Corporation as you believe it will rise in price. The stock is currently trading at $10.00. Say your trading capital is $100,000 and you want to use 20% ($20,000) to purchase the stock, and set a stop loss of 15% below your buy price. Your stop loss calculation should look like this:

Buy price $10.00 x 15% = $1.50. Stop loss equals the buy price of $10.00 minus $1.50 which equals $8.50. If the stock price was to fall below $8.50, the trade would automatically be closed.

Protecting Profit

Stop losses can also be used to protect profit in a trade that is going well. The rules that you have set out in your trading plan to enter and exit a trade will come into play here. We will cover them later in the course.

However many traders will use a trailing stop loss; which means as the stock price moves into profit, your stop loss incrementally moves with it maintaining a safe distance and always there should the trade turn against you unexpectedly.

In the above example of ABC Corporation. If you were to set a trailing stop loss $1.50 below your buy price of $10.00 and the stock reached a high of $13.50 before turning against you. The stop loss would have been executed at $12.00, locking in a $2.00 per share profit or $4000 in this case.

Until next time…Happy Trading!

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