Wednesday, March 3, 2010

Its all about risk management

I posted the chart of MDVN earlier today. I will post it again for the benefit of those who haven't seen it yet. Here it is.

Yes, it can happen. It can most certainly happen. It is a trader's worst nightmare. No matter how good a trader you are, it can happen to you. It can happen to the best of us. The scary part is not that it went down over 60% for the day. Big deal! But the fact that it gapped down over 60% and hence, those who were long coming into today, didn't even have a chance of getting out for a reasonable loss.

How do you escape something like this? Basically you can't. Like I said, it can happen to the best of us. But there are certainly ways you can minimize the effect of a loss like this. Firstly, I try not to trade any pharmaceutical stocks. A drug accepted or rejected or any announcement by FDA and it could gap either way. Like what happened with this one. But that doesn't mean that this couldn't happen to a stock from any other sector. Where does that leave you? Read on.

In the end, its all about risk management. Its all about the risk/reward ratio. I like to think that if you take care of the risk, the rewards will take care of themselves. That's why I take my profits quick and losses even quicker. But that's just me. A very important part of risk management is position sizing. And if I can "implement" position sizing with a small trading account, there is no reason why all you readers can't do so with your accounts. Here is how it would have helped you in a situation like this.

Say, I don't believe in position sizing and I went all in a stock like this. And the stock gaps down 60%. Ouch! Now to break even, I will need 150% profits on my remaining capital! Tough, isn't it?? Could take you years to break even after a loss like this.

Now let's consider the alternative scenario where the maximum I allocate in any position is 10% of my trading capital. That's still a pretty aggressive strategy if I have a large trading account. Again, my stock gaps down 60%. But now, due to my allocating only 10% of my trading capital in this stock, I suffer "only" a 6% loss on my total capital. To breakeven, I need a gain of 6.3% going forward.

150% vs 6.3%. Think about it!

No comments: