Control Risk and Loss in the Stock Market

Stock Trading Tutorial – Risk is the probability of loss. It is best to estimate it and to adjust your purchase and sell strategies to it in order to control loss before the purchase is made. Correct timing of purchases, buying near support, limiting loss potential, and stopping the decline by using volatility stop losses are all ingredients of a good risk control system. Let’s look at a few of these loss control discipline components.

One method of controlling risk is by timing purchases so that they occur at or near support. That way, your stop loss can be a very small distance away from your purchase price. If you buy when the stock is 5% above its trendline, for example, it will mean little if the stock declines 5% to reach its trendline. Since stocks often return to support, why would you sell? You would sell only if it broke to the downside through its rising trendline. Therefore, your loss would be calculated by adding the distance the sell point is below the trendline to the distance the purchase price was above the trendline. Buying at the trendline instead of above it would eliminate that unnecessary 5% loss.

However, stocks often make a small temporary penetration through a support line and then resume their climb. On the other hand, if you wait for the stock to return to its trendline before buying, you will lose only 3% if your stop is triggered.

Risk is also blunted when the downside behavior of stocks is strictly limited to predefined tolerances. For example, a trader might plan his purchases so that the projected profit is about three times the expected loss if the trade goes against him. Thus, in order to try to capture a gain of 6%, the stop loss must be no more than 2% below the purchase price. If he can reasonably expect a gain of 12%, then his stop loss would be no more than about 4% below the purchase price. Long-term investors can use a ratio perhaps as low as two to one because they have a presumptive tolerance for wider price swings and a longer time-horizon. Therefore, there is greater tolerance for negative price movement relative to the expected gain. He must put into effect more rigorous profit to loss ratio requirements.

He has no large losses. The trading pattern of amateurs is strewn with losses and gains of all sizes. Only experts consistently control their losses so that none of them are large. If you learn to control risk (limit the downside behavior of stocks), accumulated profits should be the consequence. Part of controlling risk is buying right. Any stock can be a winner if it is bought right. The bottom line is that it is more a matter of what you can keep than what you can gain. If you want to perform like an expert, develop your stop loss and selling disciplines. It is imperative that you make loss-control an integral part of your discipline.

The increased volatility of the market caused me to review my data on thousands of different strategies. The point was driven home. All these strategies exercised rigorous risk control. Sometimes they even generated more losses than gains, but they were all profitable. There was one characteristic trading pattern all the strategies had in common. They all generated consistently small losses and occasional big gains, but they never had a large gain wiped out by a large loss. There were no large losses.