“The Stock Market is Risky!”
I believe most of us would have heard the above phrase or something like that at least once in our lives. Most of the time, it is from our loved ones or friends who care about us. So let’s go through what is risk and how we go about mitigating a thing called risk.
The definition of risk is (according to Merriam-Webster Dictionary):
1) possibility of loss or injury
2) someone or something that creates or suggests a hazard
3) a : the chance of loss or the perils to the subject matter of an insurance contract
b : a person or thing that is a specified hazard to an insurer
c : an insurance hazard from a specified cause or source
4) : the chance that an investment (as a stock or commodity) will lose value
A fairly easy to understand example would be driving a car. If you drive a car without attending driving school and getting the appropriate license, it is very risky as you do not know how to handle the car in case of a situation or read the road signs. But if you attended a driving school and obtained a license, the risk is minimized as you now know how to handle a car in a situation and read road signs, etc. Now, does it mean that there is no more risk? NO! You are still at risk of an accident (most probably caused by other reckless driver or yourself for ignoring the driving rules).
Risk is always present and most people do not realise it. Every day, your life is filled with risk because you do not know if something may happen while you are walking, eating or even sleeping. The same is true for the stock market. You do not know what will happen the next day.
No one likes to lose money (I’m very sure!). But why are there people who succeed and make money and many who lost money in the stock market? It’s because those who succeed knows how to manage their risk. Those who do not, are destined to lose their hard earned money.
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong." -George Soros
The goal of managing risk is to be able to sleep at night, knowing how much is the maximum I could lose if the position goes the opposite way. Here are a few steps which is commonly found in stock books.
Step 1: Determine maximum risk you can take yet still be able to sleep (eg: 2% of total account)
Step 2: Determine a stop-loss level (even before you enter a position)
Step 3: Number of shares to buy (Step 1/ distance of stop loss to entry price)
Step 4: Maximum position size = Step 3 x entry price
So if you have a $10,000 account, is willing to risk 2% of your account, determined your stop loss to be $2 from the entry price of $10 per share. Below is how it would work out.
Step 1: Maximum risk per trade = 2% of $10,000 = $200
Step 2: Stop loss = $2 from entry price
Step 3: Number of shares to buy = ($200/$2) = 100 shares
Step 4: Total position of trade = 100 share x $10 per share = $1000
Hence, you can purchase 100 share at an entry price of $10 and have a stop loss at $8. Maximum loss on trade is only $200 which is what you are comfortable to lose. Once you control your downside, the upside will take care of itself (will explain more in the next post).
Disclaimer: This is not a recommendation to buy or sell any mentioned stocks or securities in this blog.