Three ways to limit your risk in stocks today
From Ben Morris, Editor, DailyWealth Trader:
You’re probably nervous about buying stocks…
The current eight-year-long bull market – which came after a memorable and painful crash – has most people nervous.
This is a problem. Nerves don’t help you make money or protect what you have. They only add to the likelihood that you’ll make unnecessary trading mistakes.
And nobody wants that.
Another problem with being “stock-shy” today is that we’re in a bull market… And stocks are one of the best places to make money today.
In today’s DailyWealth Trader (DWT), I aim to help you lose the nerves. The best way to do that is to have a well-thought-out plan for dealing with risk. So below, I’ll share one of the most important ways we’ve chosen to deal with risk this year in DWT.
It starts with stop losses, includes position sizing, and ends with scaling in to positions. These are three big ideas… So let’s get started.
A stop loss is a predetermined point at which you’ll sell a trading position if it reaches a certain level… no questions asked. Stop losses are designed to limit trading risk and to remove emotions from your trading decisions.
I won’t get into the nitty-gritty of how to choose a stop loss in today’s issue. But we can break down stop losses into groups, by percentages…
For example, if you think that your timing on a trade is good or that the trade doesn’t need much “wiggle room,” you might be comfortable using a stop loss that’s 10% or less below your purchase price. If you think the stock will be volatile but has huge upside potential, you might prefer to use a stop loss that’s 20% or more below your purchase price.
Choosing your stop loss is the first step. We’ll use three stop loss groups based on the risk to your initial capital: 0%-10%, 10.1%-20%, and 20.1%-50%. Each of these groups is appropriate for certain types of trades.
Next, we think about position sizing. Your position size is the amount of money you put into a stock. In general, you should feel comfortable putting more money into positions that you view as safe and likely to be profitable… and less money into riskier speculations, even if they have enormous upside potential.
For example, if consumer-electronics giant Apple (AAPL) is trading at its cheapest valuation in years (as it was last February), you should consider taking a large position size. It’s the largest company in the world and earns extraordinary profits and free cash flows.
Junior gold miners, on the other hand, are more like lottery tickets. You could make 10 times your money or more if a trade works out. But even if you do a deep analysis of a company, you may still lose money. Plus, junior gold-mining stocks are guaranteed to be volatile. So you probably shouldn’t put too large a percentage of your wealth into any one stock like those.
In DWT, we rank every trade as a low, moderate, or high trading risk. This can help you determine your position size.
Finally, scaling in means buying a portion of your planned position size initially and buying another portion (or portions) later on. In DWT, I usually suggest adding to a position only after you’re showing profits on the initial position. This way, you can keep your risk to a minimum.
Those are the three ideas you need to understand. Here’s how they come together with our DWT recommendations…
We can’t tell you what percentage of your wealth to put into any of our recommendations. We don’t know what your portfolio looks like or what your goals are. So you need to figure out position sizing for yourself. But here are some good general guidelines:
When we recommend a trade with a stop loss of 10% or less, we’ll suggest taking a full position size right off the bat. We won’t scale in. A 10% loss isn’t too bad, even with a relatively large position size.
When we recommend a trade with a stop loss between 10.1% and 20%, we’ll suggest taking a half position size. We’ll only add the other half position after we’re sitting on gains and can comfortably tighten our stop loss. This way, again, we only risk up to 10% of a full position. (That’s half of a 20% stop loss.)
When we recommend a trade with a stop loss of more than 20%, we’ll suggest taking a one-third position size. Just like with our half positions, we’ll add to one-third positions only after the trade moves in our favor and we can tighten our stop losses. This way, up to a 30% stop loss, we’re still only risking 10% of a full position size. (One-third of a 30% stop loss is 10%.)
(Normally, we’ll only recommend a stop loss of more than 30% if we have a reasonable shot at 100%-plus gains. And even then, we rarely use such wide stop losses.)
That’s our strategy. We won’t follow it to a T… But we’ll use it as a guideline.
Remember, we’re in a bull market. Stocks could continue running higher for longer than we can imagine.
So if you’re nervous about buying stocks today, don’t be. Just buy stocks in a way that keeps your risk down to a level you’re comfortable with.
Use today’s issue as your guide.
Crux note: Ben’s picks have been soaring lately. His top open stock recommendation is up 62.8% in less than two months. And he just shared his latest recommendation for gold and silver stocks yesterday. You can learn how to access all of his daily trade alerts right here.