Investing Advice: Managing Risk in the Market
By: Steve Smith
Premium Members have access to our Trade Ideas Page. Here is where I outline whether I am bullish or bearish on a particular security and what the risk level is moving forward. Many of you have heard me say things like, “We want to be long XYZ if we’re above 50”. But what exactly does that mean?
Well, to me that means that if XYZ is not above 50, we do not want to be long. Why not? Well, it means we have an elevated level of risk, if we’re below 50, that I do not want to incur. In other words, if prices are below 50, then we have 2 new risks: downside price risk (losing money) and the idea that we could have done something better with that money (opportunity cost). Both of these are not scenarios that I want to be a part of. However, if we are above 50, then yes, a long position makes sense.
How do we know that a long position is appropriate? The way to do that is by first determining who you are as an investor. What are your goals? What is your time horizon? What is your risk tolerance? These answers are different for everybody. I don’t like to risk more than 1-2% of the portfolio on any given position. So first I decide how far my entry would be from where I would admit to being wrong.
If I enter a position at $51/share and I think it’s going to $60, then if my risk level is $50 and we do not want to be long if we’re below that, I have a reward to risk ratio of 10:1. Does that fit your goals, time horizon and risk tolerance? It does for me! But you need to decide that for yourself. We’re all different.
The ability to implement this strategy consistently over time means finding a balance between money at risk and the distance from your “uncle point.” If you want to have bigger size on and therefore put your stops closer to your entry price, the chances of getting stopped out and whipsawed increase. On the other hand, if you want to give it more room, you then need to have a smaller position size to account for that added risk. No one can tell you where that balance is. You need to decide for yourself. Also See: Position Sizing
But what happens if I get stopped out, and then the stock gets back above the risk level? I think you have to be willing to get back in. The tighter the stop, the higher the chance of that stop loss order getting triggered. So if the deal you’re signing with the devil is a tight stop, then I believe you need to swallow your pride, accept the commissions and slippage and get back in if the risk vs reward still fits within your overall goals.
But what happens if I get stopped out for a second time, and then the stock rises above the risk level once again? At this point, I would reevaluate your risk level to make sure that you have the right price. More importantly, if the risk vs reward still fits your parameters, why not get back in for a third time?
I’ve had this conversation in past with some of the best traders I know. Three attempts is the common denominator here. The successful traders I talk to tend to believe that after 3 shots at it and 3 failures, then just move on to another trade. I would agree with that. There are always plenty of other opportunities out there.