Transcript of Session #3:
How To Reduce Risk When Investing And Trading
Larry here. Welcome again, to the third session of my gold WAR ROOMS! I’m thrilled you’ve joined me again today.
In today’s session, I’m going to cover some very basic concepts about reducing risk when you are either trading or investing.
This is a critical concept: Capping and reducing risk.
And what I will discuss today applies not only to gold or silver, or to mining shares. The concepts apply to any sector of the market, to anything you’re investing in, or trading short-term. And they apply to both leveraged and non-leveraged types of investment vehicles.
This is not a long session. But don’t let that deceive you. The concepts I’m about to cover in their very basic form are the most powerful rules you need to know and implement when it comes to any investing or trading. So let’s get started.
I’ll sum it all up in two words: POSITION-SIZING.
What is position-sizing? In essence, it’s money management and it seeks to answer the question — for every trade or investment you make — “How big should I make my position for any one trade?”
In other words, position-sizing is the part of your trading and investing system that tells you “how much should I buy? How many shares or contracts?”
And let me tell you, poor position-sizing, or no position-sizing at all, is the NUMBER ONE reason why most investors lose so much money and typically blow out their accounts.
After all, if you want to stay in the markets to maximize your profit potential over the short or long haul, preservation of capital is the paramount task you need to focus on. Without it, I can guarantee you will lose money and eventually be tapped out of the market.
For instance, imagine that you have $100,000 to trade. Many traders would just jump right in and decide to invest a substantial amount of this equity (say $25,000 maybe) on one particular stock or ETF.
They have no pre-planned exit or idea about when they are going to get out of the trade if it goes against them. So they are subsequently risking a LOT of their initial $100,000 — unnecessarily.
So how does position-sizing work? It works by putting your attention on the risk side of trading and not on the profits side.
I know that sounds strange. After all, most traders and investors focus on profit targets and how much they can make. But that’s wrong. What you want to focus on is your risk. Manage your risk and the profits will come!
For example, suppose you have a portfolio of $100,000 and you decide — instead of investing $25,000 in a position — to risk only 2% on a trading idea that you have. You are risking a mere $2,000.
I repeat: This is the amount RISKED on the trading idea and should not be confused with the amount that you actually INVESTED in the trading idea.
So that’s your limit. You decide to RISK 2% or only $2,000 on any given trade.
Now suppose you decide to buy an ETF that I recommend that was priced at $18 per share and the stop I recommend is 15% below that, which means that if the price falls $2.70 to $15.30, you are out of the trade.
Your risk per share in dollar terms is $2.70. Since your risk is $2.70, you divide this value into your 2% allocation — $2,000 — and find that you are able to purchase 740 shares, rounded down to the nearest share.
Now notice something important: You will be buying 740 shares of an $18 ETF — or put another way, you will be committing $13,320.
Thus, you are committing roughly 13.3% of your $100,000 in capital to this trade, BUT YOU ARE ONLY RISKING $2,000, or 2%, of your portfolio.
Moreover, since you are using only about 13% of your total equity, you can buy roughly six more stocks or ETFs with your remaining account equity.
That in turn means you can have a more diversified portfolio, with as many as seven different positions working for you at any one time, and risking no more than 2% on each of them.
Now certainly this does not sound as exciting as betting $50,000 on a trade, or $100,000 on two trades. But that’s gambling, not investing or trading, and it’s not managing your money. With that type of trading — and you’ll be amazed at how many investors trade like that — you’re better off going to a roulette table in Las Vegas and plopping $50,000 down on two different numbers.
Bottom line: Losses in the markets are inevitable. They come with the territory. If you want to stay in the game to capture the big profits that are available, then you simply MUST use position-sizing strategies to protect your capital. Period.
I cannot overemphasize how important position-sizing is. Far too many investors like to trade big positions, way too big for their accounts, and they end up blowing themselves out.
The reason is not just that they took on too big a position. The reason is that too big a position coupled with the fact that even the best traders in the world can’t be right more than about 60% of the time — meaning 40% of the time you’re going to take losses — will blow you out of the market in no time.
Proper position-sizing, on the other hand, almost guarantees success. It allows you to take losses and still make oodles of money.
For instance, suppose you risk 2% on every trade. And suppose you do 10 trades in a row that lose. You’ve lost 20% of your equity. But suppose the 11th trade is a grand slam, and you make 40%. All told — over 11 trades — you had 10 losers and only one winner, yet you now have a profit of nearly 20% net.
Think about that! Only one winner out of 11 trades, but you’re still making money!
Do the math yourself and you’ll quickly see that risking small amounts is the key to success.
So how do I use position-sizing?
Bear in mind there are actually a myriad number of strategies to position-size your trading. Not just the one I described today.
There are position-sizing strategies that take into effect the volatility of the underlying security … the average trading range … cyclical effects … and a multitude of other methods, too complex to cover today.
But no matter what method you use, the objective is the same: Keeping your risk low.
In my services and my own trading, I use two different, but very simple ways to reduce risk. The method I use for any one trade depends upon variables like volatility and average trading range.
But in both cases, I repeat, the objective is to minimize risk.
Method #1: This is where I limit the gross amount of the recommendation to roughly 5% or 10% of total equity, depending upon whether it’s a very short-term time horizon, or longer-term.
By limiting the gross amount to a small amount of your total capital, you can easily achieve the objective of reducing risk to a manageable amount. That almost goes without saying. Investing say $5,000 in any one trade versus $50,000 is obviously going to help limit your risk.
Method #2: From time to time, again depending upon certain variables, I see, I may opt to reduce risk and position-size a recommendation more like what I just described earlier to you: By stating a risk amount, which you would then use in combination with the stop I give you, to determine how many shares to buy.
This method may commit more capital to any one trade, in terms of gross dollar, but it still reduces your risk to a small percentage, which is controlled by the difference between the current price of the security and my recommended stop.
For example, suppose I tell you to buy XYZ at $20, and place a stop at $18. You then know the risk is $2 a share.
And further suppose that I tell you to risk no more than 2% of your total account equity on this trade and that you have $25,000 in your account.
2% of $25,000 means you should risk no more than $500.
Your next calculation is simple. $500 to risk and $2 risk per share means you can purchase 250 shares.
It’s as simple as that. You would then purchase 250 shares knowing that even if I am 100% wrong and you get stopped out at $18 — you are at risk for no more than $500, plus market slippage and your broker’s commissions.
Again, which method I use depends upon a lot of variables. But no matter which method I use, I will always give you a protective sell stop to help reduce risk.
As a rule, I like to keep risk at no more than roughly 2% to 3% on any one trade, regardless of which method I use. Oftentimes, I will risk as little as 1%.
There is a lot more to position-sizing than I’ve discussed today. For instance, there is the concept of learning how to trade and invest by way of what are called “R-Multiples.”
Down the road — in more webinars I plan on presenting — I will cover risk and money management in greater detail.
Don’t miss the next session of my Gold War Rooms — where I show you how I use technical and especially cyclical analysis to help me time entry and exit points and to develop my forecasts.
