Risk management is a vital part of day trading. Just like a solid trading plan, adequate risk management is meant to protect you from blowing up your account on accident. Don’t have a trading plan in place?
How should you calculate your risk?
Before you enter the trade, you should realize how much money you’re willing to bet and how much of it you’re prepared to lose. Some people prefer to go by a percentage of their account, and some prefer a flat dollar amount that they’re comfortable with.
Either way, there’s no right or wrong way to set your risk. However, you should realize that your risk is the money that you’ll lose if the trade goes wrong. For a beginner trader, it may be a very small amount, and that’s totally ok.
As you’re practicing and learning, you may lose at first, maybe even significantly. Your risk should be low enough that you can afford to lose multiple times in a row. It may be unlikely you’ll lose 50 times in a row, but you and your account should be prepared to withstand that kind of loss if you want to get the hang of how day trading works. To simplify, let’s say that your account is $100. If your risk is low enough, for example, only $1, and you lose 50 times, you’ll still have $50 to trade with. It’s not going to feel great, but at least you can recover from it.
What could go wrong?
And if you’re risking too much, one bad trade could shut your account down. There are some events that we call Black Swans; it means that something so unexpected and devastating has happened that the stock market, or a particular stock, was affected dramatically. If you get caught in one of those events, and you’re risking too much, your account may be gone with a single trade.
Another thing you should be aware of is slippage. It happens when the stock price changes in the blink of an eye. Let’s take an example where you enter the trade at $1 and risk 10 cents. By the time the price drops to 89¢, you should be out. However, in some cases, the price can drop to 70¢ within seconds, and you simply won’t have enough time to react. That may not happen regularly, but it does happen, and you need to be aware of it.
If you’re just starting to learn about day trading, you’re bound to make some mistakes. That’s how we get better; that’s what we do as humans. But that’s also why you need risk management. It is there to protect you and help you exit the trade before any serious damage is done.
In the beginning, day trading can be very emotional. Until you gain enough knowledge and experience, you may be guided by your feelings. Fear of missing out (FOMO), frustration, boredom, revenge – all these emotions are in charge if you’re not paying attention or don’t have a system to follow just yet. This is why you need to be mentally prepared for any scenario and know exactly how you’re going to end the trade if it goes against you.
Risk management and a day trading plan are your best friends in this game. Stay tuned for more information about day trading. And if you’re ready to dive in, open an account with Cobra Trading!