Managing Risk - Part II : Set clear rules

I wrote an important post on managing risk.

It is often a psychological warfare.

One can be totally paralyzed by fear that you refused to take any actions.

A common thought is that since I have lost so much, it cannot go much lower. I will wait it out for the long term. It will recover. During the dot.com bust and 2008 housing bubble market crash, you can lose 90% and never recover.

It is helpful to set some cardinal rules that must not be broken in any circumstances. It will allow you to recover if you fall into such a situation.

1. Never allow a position to loose more than 2% of the total portfolio size. If the portfolio is $100,000, and you invested $20,000, then the maximum loss is 10%. If you think you want to allow a maximum loss of 20% because the volatility of the stock is higher, then you should only invest $10,000. With options, you can monitor the whole trade structure. Any time, it is getting close to the maximum loss cut off point, be ready to get out. Often, it is better to get out even earlier. Never allow it to shoot above the maximum cut off point. It is not difficult with options. My normal loss is usually less than 10%. Sometimes it is only 1 or 2% because I do not want to waste time to continue to manage the trade as I have started on the wrong foot and the fundamentals are not to my expectations.

2. Never allow your whole portfolio to sink more than 20%. For example, if you have $100,000, and you lose $20,000, you should stop trading. Re think and re examine your strategies.

If you are using puts to protect your portfolio, you will some time to rethink before going back to readjust the strategies again. The put will protect the portfolio from further loss for a period of time.

If necessary, go back to paper trade and gain a level of confidence and success again. If you are well diversified into 4-5 segments and using options to hedge all your portfolio and maintain your discipline, you should not get into this situation. But it is hard to predict. If you get into such a situation, stop trade for a while. Take a break. Regain your mental strength, strengthen your system, design new rules, test it with paper trading before you start again.

If you follow the rules, you will survive even if are on a losing streak. You will have time to recover. It is called capital preservation – a most important concept in trading.