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How to Manage Trade Risk to Get Into the Big Winners

By: Rob Mitchell

One of the most important things about trading is the management of the risk on your trade positions. Let's face it, if the market just doesn't go anywhere while you are in a position, you just cannot gain from it. So, depending on market volatility, you really cannot control to any degree what your gains will be. You can, however manage what your losses can be to some degree with good risk management techniques.

The principle is simple but it is really hard to do (all these examples will be based on a long trade, use the opposite for shorts). When entering a trade, I simply do the opposite of what I feel. That's right, buy when the market is falling and sell, when it is rising. If trading on a daily time frame, to buy for example, I might like to see the market at a 3-5 day low, or below a moving average of some reasonable length. Then, I like the particular interval I am in to also be down. For example, I will buy on a down day.

I have attended money manager conferences and listened to industry professionals talk about how they will buy into strength. This is great in a bull market, but in today's uncertain markets, in my opinion, it is a recipe for disaster.

Let's look at the logic of it. That stock market spends a good portion of its time alternating up and down without making any ground. This is true on just about any time frame. Research suggests this is true around 66% of the time. That means you have a significant edge over random entry using this concept for trade entry alone. Further, it tells us that as the market moves higher (on a buy) there is that much less to go before it turns around and continues back down again. As a result, it can be much lower risk to actually enter a buy when the market is declining (to some measure of its alternating range) because the amount I stand to lose is lessened.

So, even though it is very uncomfortable to buy while the market is declining, I know it is reducing the amount of risk I will take on the trade at the same time.

Let's consider the psychological factors as well. If I am feeling really scared that the market is falling when I am putting on a long trade, I know most other market participants are feeling the same thing. This assures me that my fear to buy is really an indicator that measures current market sentiment. If sentiment is really that low, then I reason we must be running out of sellers to drive the market lower.

Let's look at it from a numerical standpoint on where I might place a stop loss order. If the recent previous low on the S&P is at 1280 and the market is declining into that area, I am thinking the market will likely react and go back up at that level. If I buy near that level, I can place a stop beneath it by a reasonable margin, say 1275 and have that be a reasonable measure, if it gets hit, as to whether I was really wrong or not. So as the market declines to that level, my mind is oscillating between the greed of buying the absolute low and the fear of it continuing to fall. But, for every point it falls, it is one more point reduced from my risk. At some point in this equation and mental oscillation, I pull the trigger and buy (preferably at 1280 or so, if I can get it).

Using this mental exercise to enter a trade has taught me much. I have done this for years and have been very successful with it. Now, having trained myself in this way, I experience fear if these conditions are not true. This is true because I want to get a good deal, and this translates into small stop sizes and smaller losses when I have them.

What does this mean in the big picture? By keeping my losses reasonably small and going against the majority, I do not get demoralized by trading. That keeps me in good spirits while the market is beating people up (which is just about the time it will take off for a really good move). So the famous wisdom of Rudyard Kipling stands: it is important to keep your head about you when all about you are losing theirs.

You can't win if you don't play the game. The market has a way of demoralizing its participants just before the very best moves. By keeping your risk managed, and your spirits high while trading, you will always be there when the market decides to deliver you a really big trade (the one thing you cannot control). Make sure you are there to benefit from the spoils of the trading battle.

About the author:
Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com , an internet website specializing in cyclical stock index swing trading. For more articles like this visit my blog

More Finance information like Rob Mitchell's at Credit-Voitures.com

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