Learn Money Management Best Practices for Stock Trading
One of the benefits of Trades Diary is that it helps you manage your trading account balance and risk. This is a vital piece of the puzzle in terms of becoming a successful trader and is not a simple calculation to manage without a calculator, Excel spreadsheet and/or other tools.
If you bet on a stock and do not have a stop in place to limit your risk every time you enter a trade, you are unlikely to succeed in the long run. By placing a stop in the correct place with the correct number of shares purchased, you can limit the maximum amount you lose on a particular trade to a percentage of your trading account balance.
Losing a maximum of 1% to 2% of your trading account balance on a trade is generally a safe level of loss. A good rule to follow is one that Alexander Elder recommends. If you lose more than 6% of your account balance in a particular month, stop trading for the rest of the month and take some time to reassess what you might be doing wrong.
How to Make Money in your Trading Account Consistently and Limit Risk
Risk/Reward Ration (RRR)There is an old saying to let your winners run and to cut your losses quickly. However, it is not easy to know how far a stock will travel before it reverses direction. Having a winning trade turn into a losing one is not a good feeling. Therefore, I think it is a good idea to simply take profits at a reasonable level, such as 10% above your entry price, for example, or another target price level you think will be reached.
I prefer to calculate a Risk/Reward Ratio before entering a trade, where I know my target price to take profits at in advance. By setting an entry price, a stop price, and a target price immediately when I place my trade, I can calculate a risk reward ratio when going long on a trade with the following formula.
RRR = (Target Price - Entry Price) / (Entry Price - Stop Price)By using an RRR, it is easier to manage risk, and you can set up your trades at night and not think too much about your trades while you are at your day job.
For example, we want to enter stock ABC at a price of $50 (Entry Price). We want to take profits when the stock price travels 10% higher to a price level of $55 (Target Price). We set a stop price according to some criteria, with the hope that the stock price will not travel against us and hit the stop. For this example, we pick a stop price of $48.5 (Stop Price). Plugging into the formula, we obtain the following RRR.
RRR = (Target Price - Entry Price) / (Entry Price - Stop Price)Thus, in the example above, we are risking $1 in the hopes of gaining $3.33. If we only enter trades with this exact RRR, we can have one winning trade for every 3 losing trades, and still make a profit. In other words, if we enter three trades and lose $1 per share each time, but win $3.33 per share on the fourth trade, we are up $.33 per share overall. If we purchased 1,000 shares, this translates to $333 of profit.
Generally, it is a good policy to not take trades with less than a 3.0 RRR value. This way, you can be wrong 3 times for every time you are right and break even. You can come up with your own trading rules and trading system. This is general advice.