Reducing Risk and Keeping Your Financial House In Order
Reducing risk to your money and protecting your trading capital
must come before making money in the stock market; it must
always be put first in your mind when trading. You must learn
and become comfortable with this being your first priority when
trading. I know that sounds a little strange, but it's 100% true
and a very important mindset to get into. After all, you can't
play the game if you don't have the dollars. You should always
be willing to give up a trade in order to reduce risk and save
capital.
You absolutely must seek to reduce risk and protect yourself at
every turn in the stock market, even before making a profit.
Don't get me wrong; you are here to make a profit, but never at
the expense of taking silly risks.
Always consider the risk to reward ratio of any trade you plan
to take up. What is the risk? What is the reward? Keep that
ratio in your favor and you'll be well on your way to making a
good start in the trade and protecting your trading capital. I
would rather miss 10 trades, than make 10 bad ones. Any trader
would. Bad trades, mistakes, and large risks are like leaks in a
dam. Forget about everything until you correct the leaks, and
then worry about increasing the water level.
Trading and speculation in stocks (more commonly called
'Daytrading') has been around as long as the stock market has
been in existence. Whether it's the days of the Buttonwood tree
on Wall Street, or the Bucket Shops of the 1920's, or the
electronic trading that takes place every day across the
Internet, there are and there always will be "traders".
It's certainly not difficult to imagine that the first time a
person bought a stock and saw it go up, they had the urge to
sell and take a quick profit. Daytrading is nothing new - it's
simply human nature to want to take a quick profit and then
repeat the process.
Some people would like you to believe daytrading is something
new, and that, therefore, it must somehow be "bad". However,
when you really stop and think about it, daytrading is really no
more risky than any type of investing or financial speculation.
Any investment or trade can go bad, just like any trade or
investment can go well. Just talk to anyone that has owned large
amounts of real estate for any extended period of time. There
have been times in the economy when interest rates sky rocketed
and suddenly exposure to a large mortgage has been quite risky.
No matter what the situation, speculation with any financial
instrument brings some amount of risk, especially if done
incorrectly or unwisely. Daytrading is no different.
Certainly, daytrading, like anything else, can be risky if you
don't know what you are doing. I've known of people making one
silly mistake and getting wiped out over night. Since daytrading
does come with a certain amount of risks, it's only wise to get
your financial "house" in order before you begin. As such, a few
basic guidelines are in order.
To begin, we should understand that there are two basic
categories of people that tend to seek out daytrading, and that
these two categories are drastically different in their
approaches to the markets.
The first (and more historically typical) category is made up of
people who are basically pretty financially well off. These
include individuals who have solid financial worth from other
means. They also tend to have homes, which are paid for (or
largely paid for) as well as being relatively high net worth
individuals, particularly in the liquid assets category. For
individuals in this category, daytrading most likely is only a
small part of an overall (and diversified) investment strategies
or portfolio, and typically it's only used to further an already
solid net worth without exposing a high percentage of the
individuals assets to undo risks. Basically, these are
individuals that can "afford" to do a little day trading and
typically don't go over board in "only" stock speculation.
The second (and not only more recent, but more dangerous)
category tends to be people who are attempting to build their
net worth strictly from daytrading. These are individuals who
view daytrading not so much as simply one small aspect of an
overall financial investment landscape, but more as the major
way to generate and build their entire financial worth. This
tends to also be the category of people who take larger risks
and sometimes generate a bit of negative press regarding
daytrading. This negative press would be along the lines of
people that daytrade using funds from a credit card and/or home
equity mortgage of some form or another. When things don't go
well in the markets, typically the losses tend to have a more
dramatic impact on the individual's net worth and life style.
It's pretty clear that these are two radically different
approaches to daytrading. If you are in the first category, then
as long as you do not expose more than around 10% to 20% of your
overall liquid net worth to stock speculation, you probably
won't get into too much trouble. However, if you fall into the
second category - where you are trying to create wealth through
daytrading and/or you are using daytrading as your only means of
addressing stocks - then some guidelines are in order. Of
course, at the end of the day, no one can force you to follow
these guidelines. However, if nothing else, you should strongly
consider the following information as it relates to your
individual case.
First and foremost, you should never trade using money you
cannot honestly afford to lose should some catastrophic event
wipe you out in the markets. These funds should be largely
similar to funds you would ear mark for Vegas or other forms of
higher risk speculation. In the event you lost these funds in
total, they should not have any dramatic impact on your life
whatsoever. Generally speaking, these funds should represent no
more than 10% to 20% of your overall liquid net worth. Beyond
this, you should strongly take into account areas of your
financial picture such as home ownership, outstanding short and
long term debts, as well as future responsibilities such as
college for your kids, etc. You should also take into
consideration your age as it relates to your future retirement.
Daytrading at age 20 or 30 is one thing; daytrading your
retirement funds at age 65 or 70 is a whole different situation
and very unwise unless you limit the amount of funds at risk.
Again, before you undertake anything but causal daytrading, you
should seriously consider such things as paying down all of your
short term debt. This would include paying off all credit card
balances and any loans that may be near maturity. You should
also consider allocating funds for and/or paying off longer term
debts such as car notes and/or home mortgages. Additionally, if
you have a family to provide for, you should not only consult
with your wife, husband, etc. before attempting any sort of
daytrading, but you should take into account what impact large
and unexpected losses could have on your current as well as
future living situation.
Generally speaking, unless you have tremendous earning power,
you should have very little debt and a stable housing situation
before using much capital in the markets for day trading.
Good luck in the markets!
No permission is needed to reproduce an unedited copy of this
article as long the About The Author tag is left in tact and hot
links included. Questions and comments can be sent to Ray at
articles@daytraders.com