Editor's note: We're continuing this week's series on timeless trading lessons with the one thing you MUST know before you enter any trade. If you want to be a consistent winner in the market, read on...
Tuesday, December 24, 2013
How much can I lose on this?
This is the greatest question in the world. It's the rich trader's mantra.
The people who always ask this question are consistent winners in the markets. The people who never ask it are consistent, eternal losers.
You see, the first thing most investors and traders ask themselves is, "How big are the potential gains here?" They get some hot tip from a cousin, a newsletter, or someone at work. Then they take a pile of money and throw it into a stock that could rise 200% in the next month. They focus on reward. They focus on that 200%.
Remember: Most traders lose money in the stock, options, and futures markets. You don't want to be anything like most traders. You want to focus on risk. You want the question above fresh in your mind... or better yet, taped to your computer screen somewhere.
In other words, you want to win by playing exceptional defense.
Focusing on risk and playing exceptional defense is what keeps the bogeyman of trading away from you. That bogeyman is something called the catastrophic loss. A catastrophic loss is a huge losing trade that wipes out 33%... 50%... or even 99% of your money. It's the dot-com stock so many folks were clobbered by in 2001. It's the bad condo deal they put together in 2006. It's the mining stocks they lost big on last year.
These sorts of losses can literally ruin your life. They can lead to divorce, late retirement, or so much stress it kills you.
You can use two super-simple trading tools to prevent the catastrophic loss.
One is the stop loss. This is a predetermined point at which you will sell a position if it moves against you. It can be as little as 5% below your purchase price, a middle-of-the-road level of 25% below your purchase price, or even 50%. The beauty of the stop loss is that it is set before you buy. This gets your plan in stone. So you're not trying to decide what to do on the fly while you're stressed out.
Two is something called position sizing. Position sizing is the part of your strategy that determines how much money you'll put into a given trade. If you practice smart position sizing – like never putting more than 4% or 5% of your money into any one given trade – you'll steer clear of the horrible losses folks see when they go all-in and bet 50% of their money on one hot tip.
(If you're interested in really mastering position sizing, make sure to read Van Tharp's outstanding book Trade Your Way to Financial Freedom.)
So the next time a coworker, a stock promoter, a cousin, or a financial advisor tells you about their latest great stock idea or business, shoot 'em the magic question. How much can I lose? Watch their facial expression turn to complete confusion and surprise.
If the answer is "A lot" or "I don't know," run away from the situation. If you can use the tools I just discussed to answer, "Not much, but you can make a lot," you might have a fantastic trade on your hands.
And when you start finding those win-big, lose-little situations, regularly, you'll have a lifetime of trading success.
"Investing is like a seesaw... When you can dramatically lower your chances of losing money, you've dramatically raised your chances of making it," Dan Ferris writes. But to eliminate risk from your stock portfolio, there are three things you need to do. Get all the details here.
You don't need to take on big risks to earn big returns. "All you need to do is wait," Dan writes. "Investing is like tennis. It's a loser's game... To master the loser's game, you must be patient. You must master time itself." Learn how to make 10 times your money without taking big risks here.
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