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Managing Risk and Reward in Stock Trading

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Managing Risk and Reward in Stock Trading Powered By Docstoc
					                                                 Presented by Daniel Toriola


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                                                               Risk and Reward
                                                               By John McKeon



  Risk and Reward
 by: John McKeon

If you are doing your own investing in the stock market, what would be the first question you would ask
yourself before you make any trade or investment? If your answer is how fundamentally sound the
stock is, or whether the stock just broke out of a trading range on a chart, or the fact that the stock has
gone down 50% in the last 6 months, or whether the volatility is low now so it is a good time to buy or
sell, then you are probably on the road to ruin. These strategies have nothing in common with each
other and there are all kinds of different criteria that I did not mention that have nothing in common with
each other. However no matter what type of strategy you use to make your investment decisions, there
is only one crucial question that must be asked before you pull the trigger and make the trade. That is,
what is my risk and what is my reward on this trade. Even if you are going to buy a stock and hold it for
a long time, you still have to be aware of your risk and your reward. Why? Because the entire stock
market may be here for the rest of your life, any one stock might not be. You think, that is okay I
diversified a lot so I don’t need to know risk and reward. Wrong. Diversification is great, but you should
still be aware of the risk and reward because even indexes of the entire market have a risk and a
reward, depending on the length of time invested. Point of entrance, exit, stops, and diversification,
are all important things, but they by themselves are not risk and reward. You have to ask yourself how
much am I risking, and what my potential reward is. How much are the important words

Okay how do I do that? Well first you must define your investment strategy. If you want to buy and hold
what exactly does that mean. Hold for 5 years, 10 years, or forever? What is forever? If you are 20
years old forever is different than if you are 55. Also if you are buy and holding, is forever when you
stop investing or is it when you start withdrawing money? These are important questions that must be
answered specifically. You might say it doesn’t matter because I will be diversified with index funds for
the next 15 years. Okay let me ask these questions. Are you 100% invested at all times? Do you know
the maximum drawdown (the largest loss from the index high and low in any 15 year period) for the
index you invested in? Are you able to financially withstand that kind of drawdown? Alright, I know
these are a lot of questions and all you want to do is invest in an index mutual fund for the next 15
years and forget about it. Well I am going to say right now that if you think you are taking very little risk
on 15 years you are wrong. If you bought the S&P 500 in a 100% position in 1965 and needed the
money in 1980 you would have made no return on investment and had a 40% drawdown from 1969 to

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1975. If you look at the period of 1930 to 1955, a 25 year period it is even worse. I know it’s the great
depression and things are different today. Don’t assume anything. I am not saying that you should not
invest. I am just saying that there is a risk and a reward. Every time you trade whether it is once a
week or once every 15 years, that trade has a chance of winning and a chance of losing. Also, when
you buy a managed mutual fund for 15 years you are not buying and holding. You are buying and
selling but you are paying a professional to do it for you. He or she will have draw downs in the fund
and hopefully he or she will be looking at risk and reward for you. Even an index fund held for 15 years
is not truly buy and hold because the indexes change on a yearly basis. Some stocks come in the
index and some stocks go out of the index. The longer the time span, say 40-55 years, the bigger the
risk but the bigger the reward. Also the longer the time span, the longer you can withstand a large
drawdown if it comes.

Now what if you are trading stocks with an entry and an exit point already predefined; that is where do I
get in and where do I get out. That strategy might be good but that is not risk and reward. The most
important question is how much am I invested and how much do I get out. What is the % of risk on
each stock position in the portfolio and what is the risk to the total portfolio. Let’s take an example. You
bought 100 shares IBM @50 for $5000 in a total portfolio of $200.000. You put a sell stop loss to sell
all 100 shares if IBM goes to $40 / share. That means your risk on IBM is $10 / share or $1000. But
your real risk to your portfolio is .5% or $1000 divided by $200,000. If you have a sell exit point of $100
then your reward on the stock would be 100% and the reward to your total portfolio was 2.5%. So your
total risk to reward was 5 to 1. You could crunch numbers all day to make up formulas to fit your
strategy, but the most important part is how much are you risking. Here are some general rules when it
comes to risk:

Don’t risk more than 2% on any given trade or idea. That doesn’t matter if your strategy is technical or
fundamental or discretionary. Risking 1% would be safer. Most large fund managers risk much less.

Diversify. Buying 1% risk on IBM and 1% on Dell and 1% on Hewlard Packard is a 3% risk because
they all sell the same products

Don’t risk more than 20% of your portfolio at any one time, 10% would be better. You have to have a
way to quantify the greed factor or it might consume you and all your money at the same time.

In my own portfolios I try not to risk more than 7% on an initial portfolio position.

Initial risk and on going risk can be two different risks. As a trade becomes profitable the amount of at
risk at any moment in time can be a variable not a constant. That would allow for letting profits run
while cutting losses short. However, making your initial risk a variable in most cases would be a
disaster. Once initial risk is conceived it should never be increased. Greed may become the primary
factor in increasing initial risk and that is always a fast track to increasing losses.

I hope that risk and reward become the primary strategy concern in your future investing and trading.




John McKeon- pivate placement fund manager and owner of buypanic.com, an investment newsletter.
I also have over 25 years experience in trading with a specialization in stock index trend following.

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info@buypanic.com




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                                           Risk Manage your Stock Market Trades
                                                             By Greg Secker



 Successful stock market trading is about managing risk, period. If you are currently trading and have
not mathematically generated a risk-based formula, stop trading immediately!

Trading is a numbers game. Every single trade you place must be considered as "a trade in a sea of
many trades". Some trades will work out, others will not - that's life. Your job is to make sure that the
ones that do not work out don't hit your account like a freight train - they must be risk managed. This is
why it is essential to learn how to trade on the stock market. One of the biggest causes of failure
amongst traders is the inability to manage risk and control losses.

It is very important to remember this cardinal rule: Huge Money is Only Made When a Little Money is
Risked. So what do you do if your trade drops below a pre-defined level, you must exit - no hesitation.
Sure it will hurt but as a successful trader you know that this is part of stock market trading - consider it
learning capital.

Being a successful investor or trader isn't simply about winning more trades than you lose. It's about
controlling your losses so that the profits from your wins will outweigh the losing trades. The wrong way
to pick a stock is not using any kind of system. Never just put money on a trade because it 'feels' right
- Use the reward to risk ratio to decide whether or not to invest.

You must always calculate the right amount of funds for a trade. To calculate the trade size you must
measure the potential risk against your available funds. So once you have identified a stock, the next
step is to calculate the Reward: Risk ratio using your stop loss and a realistic target price. Your
Reward: Risk ratio should be 3:1 or greater. The Reward is worked out by your target price minus the
entry price, the Risk is worked out by entry price minus where you have put your stop loss. Then quite
simply divide your Reward by your Risk. If the target profit price is at least three times the risk then the
trade makes sense. If not, look elsewhere. You may well be right, and the share may well go up, but
trading like this is too risky and will most likely lead to failure. By following these rules you can make
extra money fast.

When you next scope out a potential trade remember this advice and you will become that successful
trader you always envied.



Go to http://www.knowledgetoaction.co.uk/financialindependence if you want to learn further strategies
to trade independently FOREX or SPREADBETTING.




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                                                 Presented by Daniel Toriola




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