Introduction
No matter how much investment research is done or how selective we are, many of our trades will be losing. That’s why we need to control risk in every trade. Unfortunately, we don’t automatically know if it will be profitable or losing (otherwise, we would always avoid the losers). Losses can easily compound if not controlled. Sudden drops in stock can wipe out a large part of a trading account in minutes, especially if leverage is used. To avoid that, a maximum risk level should be set for each trade. Here’s how to do that:
How much capital to risk on each trade
How much capital you should risk depends on the size of your account, but as a general rule, don’t risk more than 1% of your account on any single trade. In other words, don’t lose more than 1% of your trading account on one trade.
If you have an account worth $30,000, you can afford to lose up to $300 on each trade; however, you can utilize all of your capital. For example, if you bought 1,000 shares of a stock priced at $29, you would have used most of your buying power ($29,000 / $30,000). As long as you don’t lose more than $300, your risk is under 1%.
Many new traders believe that risking 1% means they can only use 1% of their capital on a trade; this is incorrect. Most day traders use a large portion of their capital and sometimes more than they have (through leverage) on each trade.
Variability of trading risk
Some traders are willing to risk up to 2% of their account. This is normal if the account is smaller and the trader is willing to risk more to earn more. In the stock market, you should have $25,000 to day trade (there are some alternatives); if you risk 1%, you can lose up to $250 in a trade, which is certainly enough. If you risk 2%, you can lose up to $500.
With a larger account, set a fixed amount of risk less than 1%. For example, if you have an account worth $500,000, you can risk up to $5,000 on each trade. However, it’s not necessary to risk 1%. If that’s more than you need, choose a smaller percentage. Risking $1,000 or even $100 on each trade can provide excellent returns. As long as you are earning income that you are satisfied with, that’s all that matters. Don’t take on more risk than you are comfortable with.
Ensuring your trades don’t exceed your allowed risk limit
Now you know how much you should risk on each trade based on the size of your account. For most day traders in the stock market, risking 1% or less is optimal.
It’s important to adhere to this allowed risk limit. If you have a $30,000 account, you can risk $300. The easiest way to ensure you don’t lose more than $300 is to use a stop-loss order. A stop-loss order exits you from the trade when the price moves against you and reaches a predetermined level.
For example, let’s assume you buy a stock at $14. It seems it might rise to $14.50 but may fluctuate a bit before that. The price recently bounced back from $13.80. Consequently, place your stop-loss order below that minor support level at $13.78. The distance between your entry price and the stop-loss order is $0.22.
Remember,
You can risk up to $300. To determine how many shares you can purchase, divide $300 by $0.22 ($1,363 shares). If you buy 1,363 shares (round it to 1,300 for the best) and lose $0.22 on those shares, you have lost $299.86, which is very close to your maximum loss of $300.
Buying those shares costs 14 × 1,363 = $19,082. A large portion of the available funds was used to make the trade, however, less than 1% is exposed to risk.
Risking 1% or less is a good idea as sometimes we may lose more than we expect. Even though we set a stop-loss order, we may be subject to slippage, which results in a loss greater than 1%. Usually, slippage is minimal, provided we avoid trading around major news events and trading high-volume stocks.
The Final Word on Trading Risks
If you open an account with an amount greater than the required $25,000 for day trading, risking 1% on each trade is sufficient. Assuming you win about 50% of your trades (or more) and can achieve 1.5% to 2% on winning trades while keeping losses to 1% or less (of account capital), you will generate a good income. This may seem easy, but it requires a strong approach and good practice for trading stocks.
Risking 2% is unnecessary and is the maximum amount a stock trader should risk on a single trade. Sometimes, we may incur a loss greater than we expect; thus, starting with smaller risk is best. To accurately determine risk, set a stop-loss limit, then calculate how many shares you can buy to keep the risk under 1%. This way, each trade is optimally adjusted according to position size and account. Risk is controlled, yet it still allows for good income generation.
Source: https://www.thebalancemoney.com/how-much-capital-to-risk-on-each-stock-market-day-trade-1030861
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