Practically everyone knows the time-tested rule of not putting all of your eggs into one basket. This rule is equally applicable to trading. Consider the following example and think how would you feel if a large part of your trading capital was committed to shares in this large company.
In the above chart, the price has just fallen and fallen. If you had committed a large part of your trading capital into a position like this, you would compound the problem by then failing to cut your loss, proceeding only to watch your trading capital fade.
One of the best ways to manage your risk in the market is to limit or set a cap on how much of your trading capital you commit into a single position. This rule is so simple yet so effective in protecting you from an adverse occurrence. There have been numerous occasions in global markets of stock prices halving in value overnight. It is unfortunate, but it does happen sometimes.
The limit you set would normally be represented as a percentage of your trading capital and once set, should not be broken regardless of how confident you are about a particular share purchase. No one in the world knows what is going to happen in the sharemarket in the future, so our level of confidence with one purchase should be tempered and not influence us to break an important risk management rule.
Many would suggest that a suitable percentage to use would generally be anywhere from 10% to 25%. Anything beyond 25% of your trading capital is potentially assuming too much risk. The percentage you use should also be inversely proportional to the size of your trading capital.
For example, those with a trading capital over $100000 have the flexibility of being able to reduce the amount they commit into a single position. Whereas, those with smaller trading capital need to be prepared to risk a little more and use a limit in the order of 20 – 25%, otherwise brokerage may become a significant influence on the bottom line.
The simplest way to allocate your trading capital is to adopt an equal portion model. This suggests that you simply break up your capital into equal pieces and commit that amount to every trade, which could be done using the percentage discussed earlier. This rule does not suggest that you necessarily always commit your limit in every position; it is simply setting a maximum limit.
Another consideration is how many trades you will have at any one time. Ideally you want the vast majority of your trading capital committed at any one time to make the most of your capital. However, you need to consider your comfort level and managing your exposure in the sharemarket.
When you have many positions open, you need to manage all of them. This implies monitoring the share price periodically and adjusting your exits. You also need to conduct further analysis and look for further trading opportunities. This places varying demands on all of us and the number of positions open will be influenced by how comfortable you are following your trading strategy and how much time you have to commit to it.
One thing is clear however, and that is we all have a different tolerance to risk. This suggests that when it comes to deciding upon our own specific risk management rules, it really is a matter of personal choice. Always be cognisant of the guiding principles and you will go a long way to managing risk effectively and trading well.