A Basic Rule for Limiting Risk
Any successful trading strategy must comprise three important components. The problem is that one of these components is much more important than the other two. Most new traders don’t know this.
Component #1
The obvious first step is establishing an entry point. This is the part of the trading strategy that tells us when to enter the market with a position. It can be a technical (chart pattern) or fundamental (lower Retail Sales report) reason. Regardless, this is where everyone must begin.
Component #2
The second component of a good trading strategy is the target or exit price – where you should get out to make the profitable. This requires determining where the market will go once you enter a trading position. Pretty self-explanatory.
It’s the third component that is the most overlooked. To be more accurate, it is within the third component that traders tend to overlook a key component that can hugely impact trading results.
Component #3
The third and most important part of a trading strategy is your protective stop loss order. Most people understand that a stop order can protect a trading position in case it is unprofitable. But there is more to it than that.
When you take on a trading position, you assume a risk. Anytime there is risk, you take a chance on losing money in the markets — and that is the number one reason to use a stop loss order.
Most people overlook a specific part of the protective stop loss. I call it the “Maximum Defined Loss.”
The Maximum Defined Loss is the maximum dollar amount you are willing to lose on any given trade. You have to define it and stick to it consistently. If your Maximum Defined Loss is $300 per trade, you will never, ever take more risk than $300 on any given trade. And you stick to that always!
This doesn’t mean you will take a $300 risk on every trade. It means you will never take more than a $300 risk on any trade. ($300 isn’t the amount of money everyone should use; it’s a personal choice.)
Again, you should stick to that rule at all times without exception.
Unfortunately, most people decide after they get in a trade how much risk to take. That is a mistake. A good trader determines the amount of risk beforehand and always sticks to his Maximum Defined Loss.
A good way to determine your Maximum Defined Loss? Never risk more than 3.5% for day trading and 7-10% for long-term trading. In other words, if you are a day trader and you have $10,000 in your account, you would never risk more than $350 on any one trade.
This is the most overlooked component of a trading strategy. Every trader should be using the Maximum Defined Loss to limit the amount they lose on any given trade. This gives your trading strategies more structure and discipline.
Larry Levin is the Founder & President of Secrets of Traders – a commodity trading educational firm dedicated to helping traders succeed in the futures markets. Larry trades the S&P 500 at the Chicago Board of Trade (currently known as ‘The CME Group’), now the world’s largest and most diverse financial exchange. Larry has been trading his own account or company’s proprietary accounts since 1993, trading an average of 2500-3000 E-mini S&P contracts a day.
Larry appears regularly on CNBC, Bloomberg Television, Rob TV, BizRadio, as well as various other media outlets, providing his expertise and insight on the current market.
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