Day Trading Basics For Beginners  – Lesson 3: Risk and Account Management

Day Trading Basics For Beginners  – Lesson 3: Risk and Account Management

To be a successful day trader, you need to master three essential components of trading: sound psychology, a series of logical trading strategies, and an effective risk management plan. These are like the three legs of a stool – remove one and the stool will fall. It is a typical beginner’s mistake to focus exclusively on indicators and trading strategies.

A good trading strategy delivers positive expectancy; it generates greater profits than losses over a period of time. All of the strategies outlined in Lesson 7 have been demonstrated, if executed properly, to show positive expectancy. But, keep in mind, even the most carefully executed strategy does not guarantee success in every trade. No strategy can assure you of never having a losing trade or even suffering a series of losing trades. This is why risk control must be an essential part of every trading strategy.

The inability to manage losses is the number one reason that new traders fail in day trading. It’s a common human inclination to accept profits quickly and also to want to wait until losing trades return to even. By the time some new traders learn to manage their risk, their accounts are badly, if not irreparably, damaged.

To be a successful trader, you must learn risk management rules and then firmly implement them. You must have a line in the sand that tells you when to get out of the trade. It’s going to be necessary from time to time to admit defeat and say, “I was wrong,” or “The setup isn’t ready yet,” or “I’m getting out of the way.”

I’m generally a successful trader, but I still lose frequently. That means I must have found a way to be a really good loser. Lose gracefully. Take the losses and walk away.

I can’t emphasize enough how important it is to be a good loser. You have to be able to accept a loss. It’s an integral part of day trading. In all of the strategies that I explain in Lesson 7, I will let you know what is my entry point, my exit target, as well as my stop loss.

You must follow the rules and plans of your strategy, and this is one of the challenges you will face when you are in a bad trade. You may very likely find yourself justifying staying in a bad trade by saying, “Well, you know, it’s Apple, and they make really great smartphones. They’re definitely not going out of business. I’ll just hold this a little longer.”

You do not want to do that. You must follow the rules of your strategy. You can always get back in, but it’s hard to recover from a big loss. You may think, “I don’t want to take a $50 loss.” Well, you definitely don’t want to take a subsequent $200 loss. And if you ended up taking an $800 loss, it would be really hard to recover from that. Take the quick losses, get out, and come back when the timing is better.

Every time you trade, you’re exposing yourself to the risk of losing money. How do you minimize that risk? You need to find a good setup and manage the risk with proper share size and stop loss.

Here is my next rule:

Rule 5: Success in day trading comes from risk management – finding low-risk entries with a high potential reward. The minimum win:lose ratio for me is 2:1.

A good setup is an opportunity for you to get into a trade with as little risk as possible. That means you might be risking $100, but you have the potential to make $300. You would call that a 3 to 1 profit-to-loss ratio. On the other hand, if you get into a setup where you’re risking $100 to make $10, you have a less than 1 risk-reward ratio, and that’s going to be a trade that you should not take.

Good traders will not take trades with profit-to-loss ratios of less than 2 to 1. It means if you buy $1,000 worth of stock, and are risking $100 on it, you must sell it for at least $1,200 so you will make at least $200. Of course, if the price comes down to $900, you must accept the loss and exit the trade with only $900 ($100 loss).

If you cannot find a setup with a good profit-to-loss ratio, then you should move on and keep looking for another trade. As a trader, you are always looking for opportunities to get low risk entries with big win potential. Being able to identify setups that have big win potential is also part of the learning process. As a beginner trader you may not be able to differentiate between a range of setups. It may be difficult for you to recognize what is a home-run Bull Flag and what will end up being a “false breakout”. That’s something that comes with both experience and training. We will cover this in more depth in the coming lessons. You can learn from videos on YouTube and Google. You can also join our private chatroom (free to you) in www.Kingtrader.netwhere I explain my trades in real time while I am trading them. You will be able to observe me and my monitor and my trading platform.

Using a 2 to 1 win:lose ratio, I can be wrong 40% of the time and still make money. Again, your job as a day trader is managing risk, it is not buying and selling stocks. Your broker is buying and selling stocks for you in the market. Your job is to manage your risk and account. Whenever you click “buy” in your trading platform, you expose your money to a risk.

How do you manage that? You essentially have three steps in managing risk. You need to ask yourself:

1. Am I trading the right stock?

Lesson 4 focuses on finding the right stocks for day trading. I will explain in detail how to find stocks that are suitable for day trading and what criteria you should look for in them. You must avoid stocks that (1) are heavily traded by computers and institutional traders, (2) have small relative trading volume, (3) are penny stocks that are highly manipulated, and (4) don’t have any reason to move (no fundamental catalysts). I will explain these in more detail in Lesson 4. Do remember that risk management starts from choosing the right type of stock to trade. You can have the best platform and tools and be a master of strategies, but if you are trading the wrong stock, you will definitely lose money.

2. What share size should I take?

One share, 10 shares or 100 shares? What about 1,000 shares? This depends on your account size and your daily target. If you are targeting $1,000 a day, then 10 or 20 shares might not be enough. You either have to take more shares or increase your account size. If you don’t have enough money to trade for a $1,000 daily target, you should lower your daily goal.

I am holding around $25,000 in my trading account and I usually choose 800 shares to trade. My daily goal is $500 or $120,000/year. That is sufficient for my lifestyle. What is your trading goal?

3. What is my stop loss?

The absolute maximum a trader should risk on any trade is 2% of his or her account equity. For example, if you have a $30,000 account, you should not risk more than $600 per trade, and if you have a $10,000 account, you should not risk more than $200. If your account is small, limit yourself to trading fewer shares. If you see an attractive trade, but a logical stop would have to be placed where more than 2% of your money would be at risk, then pass on that trade and look for another one. You can risk less, but you should never risk more. You must avoid risking more than 2% on a trade.

Step 1: Determine your maximum dollar risk for the trade you’re planning (never more than 2% of your account). Calculate this before your trading day starts.

Step 2: Estimate your maximum risk per share, the strategy stop loss, in dollars, from your entry. This comes from the strategies set out in Lesson 7, where I explain in each strategy what the stop loss should be.

Step 3: Divide “1” by “2” to find the absolute maximum number of shares you are allowed to trade each time.

For example, if you have a $40,000 account, the 2% rule will limit your risk on any trade to $800. Let’s assume you want to be conservative and risk only 1% of that account, or $400. That will be Step 1.

Suppose you look at the stock of BlackBerry (ticker: BBRY) for ABCD Pattern Strategy (lesson 7). You buy the stock at $16 and want to sell it at $19, with a stop loss at $14.50. You’ll be risking $1.50 per share. That will be the Step 2 of risk control.

For Step 3, calculate your share size by dividing “Step 1” by “Step 2” to find the maximum size you may trade. In this example, you will be allowed to buy only 266 shares (or rounded to 250 shares).

With the strategies introduced in Lesson 7, I explain where my stop loss would be based on technical analysis and my trade plan. I cannot consider maximum loss for your account because I of course don’t know your account size. You need to make that judgment for yourself. For example, when your stop would be above of a moving average, you need to calculate and see if that stop would be bigger than your maximum account size or not. If break of moving average will yield a $600 loss, and you have set a $400 maximum loss per trade, then you should either take fewer shares in that trade or not take that trade at all and wait for another opportunity.

You may correctly argue that it will be difficult to calculate share size or stop loss based on a maximum loss on your account while you are waiting to jump into a trade. You will need to make a decision fast or else you will lose the opportunity. I understand that calculating your stop loss and maximum loss in your account size in a live trade is difficult. Remember Rule 1? Day trading is not supposed to be easy. Trading needs practice and I strongly recommend that new traders paper trade under supervision for at least three months in a live simulated account. It sounds crazy at the beginning, but you will quickly learn how to manage your account and your risk per trade. You will be amazed at how rapidly the human brain can do calculations on what share size to take and where to set the stop loss.

A burning question when you begin your trading career is “Why do most traders fail?”

Day trading requires you to make quick decisions and at the same time to be very disciplined. When you hear breaking news that an activist investor has just taken a stake in Amazon.com Inc., your initial reaction might be to load the boat. I can hear the logic that compels you. “Let’s buy 5,000 shares in Amazon! Let’s put on a big order!” But you need to be able to make a quick decision on whether you should buy or sell or sell short that stock, and you need to make that call with discipline.

My trading strategies slowly improved with time, but the breakthrough came when I realized that the key to winning was controlling myself and practicing self-discipline. It is hard enough to know what the market will do, but if you don’t know what you will do, the game is lost. New trading strategies, tips from me or from this post, or even the most sophisticated software imaginable, will not help traders who cannot handle themselves.

You must ask yourself questions:

• Does this fit into my trading strategy?
• What strategy will this fit into?
• If this trade goes the wrong way, where is my stop?
• How much money am I risking in the trade, and what is the reward potential?

This is what many traders find difficult. All of these decisions, the very process of making sure these decisions fit into your risk tolerance and your strategy parameters, are a tough multitasking call. Not only is it multitasking, but it is multitasking while under stress.

I understand that stress. There have been times when I’ve been in the trade, had $15,000 in shares, and all I needed to do was sell. But as I was looking at my keyboard, I couldn’t even figure out which keys to punch. This sort of paralysis is not unusual when you’re overwhelmed. Whenever that happens, you need to realize that you have pushed yourself a little too far out of your comfort zone. It happens to every single one of us. Expect it to. Once you have some experience under your belt, it’s good to work on the edge of your comfort zone so you’re always pushing your boundaries. However, if you find yourself too far outside of your comfort zone and outside of your risk tolerance, you can end up making some significant and costly mistakes.

I encourage you to foster a state of self-awareness within yourself. Dial in:

• Are you focused?
• Are you calm?
• Are you making good decisions?

Be in touch with the results of your decisions and constantly be reviewing your performance.

• Are you trading profitably?
• Have you had five winners in a row or have you had five losses in a row?
• If you are on a losing streak, will you be in touch with your own emotions and maintain your composure, or will you let your judgment?

I cannot overstate how critical that skill will be.

Consider skill and discipline to be your trading muscles. Muscles require exercise to grow and, once you’ve grown them, they need to be exercised or you will lose them. That’s what I experience every day: continually exercising my ability to practice self-control and discipline.

Some of these skills, however, are comparable to learning to ride a bicycle. Once you’ve learned it, riding a bike is a skill that can’t be taken away. Once you’ve learned it, the skill of identifying a good stock chart isn’t going to go away. But remember, discipline is something you will need to constantly work at to be a successful trader. You’ve entered a profession in which you will always be learning. That’s great. In fact, it’s better than great – it’s stimulating. But it’s important to remember that if you start to get over-confident and think you’ve outsmarted the market on trading wisdom, or that you don’t need to learn any more, you’ll often get a quick reminder from that market. You’ll lose money and you will see that the market is correcting you.

I will reiterate: being able to make quick decisions and being able to make and then follow your trading rules are critical for success in the market. As you continue through this post, you are going to read much about risk management. Everything that traders do comes back to risk management because ultimately it is the most important concept for a trader to understand. All day long, you are managing risk. Related to this is the ability to manage risk so that you will make good decisions – even in the heat of the moment.

That’s the next rule of day trading:

Rule 6: Your broker will buy and sell stocks for you. Your only job as a day trader is to manage risk. You cannot be a successful day trader without excellent risk management skills, even if you are the master of many effective strategies.

As mentioned before, traders are in the business of trading. You need to define your risk as a business person – the maximum amount of money you’ll risk on any single trade. Unfortunately, there is no standard dollar amount that I can suggest. As explained earlier, an acceptable risk depends on the size of your trading account as well as on your trading method, personality and risk tolerance. But remember the 2% rule explained above. It is worth repeating:

The absolute maximum traders may risk on any trade is 2% of their account equity. For example, if you have a $30,000 account, you may not risk more than $600 per trade, and if you have a $10,000 account, you may not risk more than $200. If your account is small, limit yourself to trading fewer shares. If you see an attractive trade, but a logical stop would have to be placed where more than 2% of your equity would be at risk, pass on that trade and look for another trade. You may risk less, but you may never risk more. You must avoid risking more than 2% on a trade.