Friday, July 3, 2015

Importance of Risk Management in Trading or Dumb Mistakes that I Did Recently

Well, the time has arrived for me to come clean with my latest mistakes. I plan to write a post at the end of every month, where I would share with my major mistakes and what I have learnt from them. 

There are several reasons why this might be a good idea. In the below paragraphs, I list some of the reasons and give short description for each one of them.

1) Being able to measure results, is one of the elements of SMART way of doing things. In the business of trading/investing, this comes through analyzing past trades and establishing major mistakes to learn from them to decrease the probability of repeating them in the future. I say decreasing, but not eliminating, because, we are all human beings and we will make mistakes in the future, as we have emotions that will constantly interfere with our common sense judgement.

2) Writing about my mistakes, will help me crystallize the actual reasons that lie behind the mistakes I did during the month. Thet should ideally help me become less prone to repeating the same mistakes.

3) Paying attention to mistakes, is in my view is more important than paying attention to successfull trades. The reason for that, is the belief that by minimizing the mistakes that incur will eventually help the ultimate goal of growing capital.

So, let's dive in and see what mistakes helped me stay poorer in the month of June 2015,

Mistake #1: Not cutting losses as soon as possible. Or in other words not having a disciplined approach to exiting the trade.

This mistake undoubtedly is a deadly one. If there is one deadly disease that can kill a small time retail investor, with limited resource base, this is it! This is a mother of all diseases, that MUST be avoided at all costs. Ok, it might sound melodramatic, but truth is that cutting losses is the tool that any investor has to utilize, especially retail investors such as me. We are trying to make a living from markets, that's why it is essential we have a dry powder at the beginning of a new day to fight for the income. As the famous saying goes, one has to stay in the game to stand to fight another day. There is always a new day, with new opportunities, that will give to a patient investor plenty of opportunities to profit. 

Example: I have bought AAPL Jan 16 LEAPS, but overstayed the decline in the price of opton calls. I should have exited the trade the minute it had reached no more loss territory! But...I didn't, and as you have guessed, it made me suffer a lot.

Mistake #2: Being not patient with trades. That is right. This is in the class of major mistakes that should also be avoided at all costs. The next mistake below explains in detail the algorithm of the correct trade, and shows the ways the successful trades has to be executed. And to do that successfully, I have to learn to be patient with my ideas and not rush for the first idea that came to my mind. I have to search for ideas that are around their major support and resistance levels, where I can place my NMLPs and define the risk level.

Mistake #3: Not having an exit strategy. Before entering the trade, I have to have two numbers written and prepared. First is the entry price, that has to be based on the price of my risk level. The risk level is the price that I call “ No More Loss Price” or “NMLP”. So, before entering the trade, I have to define the amount of capital that I can stand to risk (for instance in the case of options - $200) then determine the position size (number of shares of contracts), then only search for a suitable entry price. The entry price has to be around major support levels, that theoretically might give me an upside with a determined risk level. After having established the NMLP, the amount of capital to risk, and entry price, I can start the trade. Then I should hope for a move in the direction of my bet. It does, then I should aim for 5-1 reward to risk payout, and at least 3-1. However, it all depends on the situation, and if I suspect the price might move in the opposite direction, I should close the position in the green. The same thing goes for the moves at the loss level. In case, I am convinced that the stock might move lower than my loss level, I should close it before it hits the NMLP.

Example: Let’s say that WMT is trading at $72, with a major resistance level at $70.50. So, at $72 the most it has to move $1.5 to hit a resistance. My NMLP has to be placed at around $70.50 level. And considering the fact that my risk for capital is $200, my position can’t be more than $200/$1.50 = 133 shares! (or 133*$72 = $9576) According to my risk to reward ratio of 1-5, I should expect a gain of $200*5 = $1000. For this scenario to come to life, the stock price has to move more than $1000/133 = $7.51 and reach $7.51+72 = $79.51

In this example, I am using a common sense way of first identifying the resistance level that the stock might fall to, and then I calculate the most amount of capital that I can risk for this trade. However, in the daily trading, I tend to cling to favorite stocks, rather than search for companies that have moved closer to major resistance and support levels. This is what I should focus on.

Well these are some the mistakes from the month of June 2015. Please share your mistakes from the month of June, that you incurred in your trading/investing processes.

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