I will be sharing with you the third step of my 4 simple steps formula to achieve success in investment and trading. (You can refer to the previous issue for the articles on the first 2 steps of my S-T-P-M formula or email a request to [email protected])
This third step is the main differentia- tor between the successful investors or traders from those who did not make it or give up half way. It is about how you protect your investment or trades, staying in the game despite of losses to prevail for long-term success.
Losses are Part of the Trade
Yes, no matter how much research, analysis and due diligence we put in before we invest or engage into a trade – things can still go wrong. There are factors affecting the stock market that are beyond the company’s control, natural disasters being one of it!
We are brought up in an education system where failure means we are not good enough. What would parents usually say when their child comes home from school with a score of 90 out of 100 in an exam? “Why didn’t you get 100, where did you go wrong?” “How many got 100?” See what I mean? After training people on trading psychology for the past 4 years, I see that the
fear of failure has stopped many people from progressing, as well as causing many to self-sabotage their results and destroy what could have been a successful career as a trader.
“It is not whether you are right or wrong that is important, but how much money you make when you are right and how little you lose when you are wrong” said George Soros, investor and philanthropist with the net worth of US$20 billion.
I hope I have stressed enough that the skill and attitude to manage losses is a “must have” for all investors and traders. Let us talk about the Risk Management princi- pals that I personally adhere to.
I never risk more than 2% of my capital on a single trade. In other words – if I am on the losing end of a trade, I will make sure my loss is limited to only 2% of the value of my portfolio.
Allow me to illustrate how it is done, so that you are clear on how to implement this rule.
Let say you have a total of RM100,000 in your investment portfolio and you have decided to buy a company stock called “XYZ”, what the professionals will do at this point is to decide the price to sell and to make profit and also to cut loss if the stock goes down. We do this by determining the key “Support” line for the stock. We will cut loss if the price goes down below this “Support” level plus some buffer. So assuming the determined Cut Loss point is RM9.00, then the amount of risk we are willing to take is RM10.00 – RM9.00 = RM1.00. Given 2% of RM100,000 is RM2,000; then the number of units we can buy here is RM2,000 ÷ RM1.00 = 2,000.
I have seen many investors deter- mine the number of units to buy with their “intuition”! Imagine if you have a proven working strategy, with a 70% winning probability – which means you should be winning 7 out of 10 times on average. And you decided to risk 25% of your capital each time when you trade. What will happen if you have 3 consecutive losing trades? You would have lost 75% of your capital! What if you have 4 losing trades consecutively? Your capital would have been wiped out just like that!
Reward over Risk Ratio
So what if you have a strategy with a 50% winning probability – which means you are right only half the time. Can you still make money?
The answer is YES! If you follow the capital preservation rule we have discussed earlier, AND you only choose to invest or trade when the reward over risk ratio is AT LEAST 2 to 1. Which means for every RM1.00 you risk in a stock, you should have enough data to support the expecta- tion that the stock will go up to RM2.00 to make it a good deal.
As you can see from the example – assuming you start with a capital of RM5000 and enforce the 2% per trade rule, you will still end up with a 10% profit with 10 trades (RM500 over RM5000) even if you are only half right!
To summarize what we have gone through so far – following strict risk management rule and choosing only trades with good reward over risk ratio is the key to protect your investment.
Hedge for Additional Safety
As defined in Investopedia, hedging means “making an investment to reduce the risk of adverse price movements in an asset”.
Let say you have carefully selected and invested in a portfolio of growth stocks a few months back, and now you read about some looming uncertainties in the market that may cause a dip in stock prices. What would you do? Wait and see while doing nothing? Or act on fear and sell off everything in your portfolio? Either of those choices is far less than ideal, because you could have lost much less than you should if you took an action earlier, or you could lose out on the opportunity to make profit if the dip did not happen. I would hedge my portfolio in these situations.
One example of hedging would be by selling the Index (by using Futures, or in other markets – CFD). Assum- ing that we have done our part of selecting fundamentally strong companies – the stock price of these companies will usually drop in less
magnitude compared to the market Index. Thus, whatever we have lost in the dip of stock price will be covered by the gains we make in selling the Index.
I have just given a very brief description of how hedging works, and there are many ways to do it. The key to effective hedging is to know when to do it, what to hedge with and how much to hedge against.
Although this technique is commonly used by professionals, I believe all investors and traders should learn how to do this; otherwise you will be missing out on a great way to reduce your risk down to the very minimum. I am also confident that this is a very learnable skill because we have trained hundreds of new investors and traders on how to do it.
In the next article – I will cover the fourth and last step – how to Multiply your profit safely with leverage instrument like Options and CFDs, so stay tuned for the next issue!