Introduction: Navigating the Trading Waters Safely
Renowned investor Warren Buffett once famously said:
“Rule No. 1 is never lose money.
Rule No. 2 is to never forget rule No. 1.”
Buffett was talking about investing in the financial markets. However, there is another side to it too – if someone is making profit in business, someone else will suffer a loss. This is especially true for the derivatives market which is a zero-sum game.
There will be days when you feel like the Warren Buffett of the stock market, and there will be days when something as innocuous as a fat finger can burn a hole in your pocket.
Here, we’ll explore how to avoid or minimize your chances of a trading loss.
Setting Loss-Limit Rules
Every trader should employ a loss-limiting system to limit losses to a certain percentage of assets or capital employed in a single trade.
Loss-limit rules are essentially predefined limits that limit the amount of loss you are willing to endure either on a single trade or over a specified period of time. Widely used loss-limit rules include a 2% loss limit per trade and a 6% monthly loss limit. However, these percentages are not sacrosanct and may vary depending on your risk tolerance and trading skill level.
2% Loss-Limit
The 2% rule is a simple but effective principle: never risk more than 2% of your trading capital on a single trade. The purpose of this rule is to preserve your capital by ensuring that losses from any trade do not significantly impact your trading account.1
John C. Hull. “Options, Futures, and Other Derivatives.” Pearson, 2018. Pages 396-8.
For example, let’s say a trader has a trading account with $10,000 capital. Following the 2% rule, the maximum amount that can be lost on a single trade is $200 ($10,000 x 2%). If a trade turns unfavorable, the trader has the means to mitigate losses and keep a large amount of capital available for future trading.
6% Monthly Loss Limit
The 6% monthly loss limit rule acts as a limit on the total loss you can incur in a month. This rule is a guide to help ensure that you do not lose too much capital in your trading account in a single month.1
Continuing the last example, if your account balance at the beginning of the month is $10,000, the 6% monthly loss limit translates into a maximum loss of $600 for the month ($10,000 x 6%). If cumulative losses reach this limit, your trading is halted for the rest of the month to prevent further losses.
Like the 2% rule, the 6% monthly loss-limit principle has variations proposed by different experts. Some suggest a strict limit of 4%, while others consider an 8% monthly loss limit to be appropriate, depending on the risk profile and trading strategy.1
These loss-limiting rules aren’t just about raw numbers; They epitomize the fundamental risk management philosophy to achieve longevity and stability in the turbulent business world. By following these rules or your personalized variation, you can maintain a disciplined approach, ensuring you are financially alive to trade another day
Stop-Loss Orders
Stop-loss orders are a defensive strategy employed by traders and investors to limit potential losses and protect profits. It is essentially an order placed with a broker to buy or sell a security when it reaches a specified price, known as the stop price. When the stop price is reached, the stop order becomes a market order, meaning the order will be executed at the next available market price. This tool is helpful in managing risks, especially in volatile markets
Understanding Stop-Loss Orders
Buy-Stop Order : This stop order is placed above the modern market price. It is commonly used to buy after breaking a security level, indicating a potential uptrend.
Sell-prevent order : This is positioned under the modern-day marketplace price. It is used to sell a security to prevent further losses or to protect profits on a position a trader already has.
The Benefits of Stop-Loss
On the other hand, if you are considering a stock trading at $50, but want to buy it only if it shows an uptrend by breaking the resistance level of $52, you can place a buy-stop order at $52 . Once the stock price reaches or exceeds $52, the buy-stop order is activated, and shares are purchased at the next available market price.
Stop-loss orders are a prudent aspect of a complete risk management strategy. They help you minimize losses and maintain a disciplined and systematic trading approach which is vital for long-term success in the turbulent world of trading and investing. Here are some benefits:
A limit on losses : The primary advantage of using stop-loss orders is the ability to set a limit on potential losses. With preset exit points, traders can have peace of mind knowing that their losses will not exceed a certain level.
Protecting profits : Stop-loss orders can also act as a tool to protect trades in which unrealized profits have accumulated. For example, if a stock purchased at $20 rises to $30, a stop-loss order can be placed at $28 to protect some profits.
Emotional relief : Trading often gives rise to strong emotions, especially during adverse market conditions. Stop-loss orders automate the selling process, preventing impulsive decision making driven by fear or greed.
Disciplined trading : Stop-loss orders implement a disciplined trading approach by automatically following a predetermined risk management strategy,
Note
When it comes to the markets, sometimes losses are inevitable. However, these financial setbacks can be reduced to a great extent by taking a disciplined approach and taking advantage of systematic methods.
Using loss-limit rules, stop-loss orders, and put options are good strategies to manage risk. These strategies provide a safety net against adverse market movements and provide more informed and controlled trading decisions.
As you deal with the ups and downs of market conditions, having a strong risk management framework is the cornerstone for long-term success and stability as you seek to achieve your financial goals.
