Having a plan is necessary because of the emotional effects markets can have on our decision making. You need to make most of your decisions in a disciplined, unemotional state. Emotions will have you selling too soon or holding on too long. They will have you make buy and sell choices that you will look back on in disbelief. "How could I do something that dumb!" you will say, "what was I thinking selling there!". These thoughts will occur too often if you don't plan ahead.
Therefore, we need a plan!
First and most importantly, we need to control risk. i.e. how much are we willing to lose by buying this stock? A general rule for managing risk is by using the 2% rule. Lets say, for the sake of discussion that we have a $10,000 account for investing/trading. The 2% rule states that the most you can lose on any one investment is no more than 2% of your total account balance. In this case 2% of 10,000 is 200. This means that the most you are willing to risk losing on one trade is $200. What this allows is for you to sustain a string of losses and not do major damage (blow up) to your account.
Which brings us to Stops. Stops must be your friend. Learn to trust your Stops and they will save your account. A Stop-loss is simply a price for the stock where your thesis for the trade is proven wrong. This could be a price just below a major support area, an indicator like Volatility Stop, or a moving average support area.
Using the 2% rule and support Stop-loss, how do we enter a position in ATT? Based on only risking 2% of our total 10,000 account (200), we buy T at today's closing price of 33.75 and our stop for ATT is just below 32.75. The difference from the price we bought at (33.75) and the stop price (32.75) is $1.00. Meaning we stand to lose $1.00 per share by triggering our stop and having to sell. If we can lose $200 on a trade and stay within our risk parameters, we can buy up to 200 shares of T on this trade.
Ideally you would like to buy the stock very near to the support area so you can risk even less than 2%. The less you risk the better. If you are buying right on the support area you will know very quickly if you are right or wrong.
Risk management is the single most important aspect of your trading plan. It will keep you in the game by cutting your losses short and not letting them turn into large losses.
A breakdown from a support area can create a huge loss. Here is a recent example of that in AAPL:
If you chose to not obey your support stop here because you like Iphones or think Apple's stock should never go down, well you sure got a groin kick of reality.
No matter how good you think a company is or how groundbreaking a product is, a stock can always go lower and lower. This is why you must NOT go with your "feelings" and must stick to your Stops.
Having a simple understanding of risk management puts you ahead of most investors and will keep you relatively safe from the dangers of the markets. The only thing we can control when investing in the markets is how much we are willing to risk. We can't control if it goes up or down, but we can control the parameters for where we are still correct in our ideas or where we have been proven wrong. The very first thing you must consider when you want to buy a stock is where your stop-loss will be. Where is the support? Where would support be broken? Those are the questions that need to be in your head when you are considering entering into a new position.
Next time we will discuss simple trading strategies and how to implement them into our risk management plan.
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