Free Information to Help You Build Wealth in the Stock Market
Category Archives: Risk Management
November 14, 2013Posted by on
Perhaps no concepts is more well-known by the investing masses than diversification. The mere mention of the d-word usually conjures up images of eggs in a basket. Of course, this imagery arises from the popularity of the old advice to avoid placing all your eggs in one basket. Such an isolated bet runs the risk of losing too many eggs due to a single unforeseen basket drop. The safer approach, then, is to spread your eggs among numerous baskets.
In the context of investing the eggs represent money, or one’s trading capital, and the baskets represent different investment choices such as stocks, bonds, or real estate. Or, for a pure stock trader the baskets may represent buying multiple, preferably uncorrelated, stocks.
While egg spreading is a well-known form of diversification there are two other types of diversification worth consideration in your investing ventures: time and price diversification.
Time diversification adds in an additional measure of protection by spreading your bets over time. In other words, staggering your entry into multiple stocks over time is less risky than buying ten stocks all on the same day. This insulates you from losing too much money on any one big market selloff. For example, if you were looking to buy ten stocks it would be less risky to buy one every two days for the next month than to buy them all today. This tactic reduces the risk of incurring your max loss on all trades simultaneously.
Even if the market plummeted at the end of the month when you owned all ten stocks, they would be at different stages of their progression. Instead of incurring the max loss on all ten trades you would probably lock-in a gain on some, break-even on others, and only lose on a few.
Price diversification is the idea of buying shares of a stock over time as opposed to all at once. That way if prices decline you’re able to buy more shares at cheaper prices which lowers your average cost basis. In other words, we’re dollar cost averaging. Admittedly, this is probably a technique best suited for longer-term investors.
Suppose you have $10,000 you’d like to invest in the stock market in aggregate by purchasing the S&P 500 ETF (SPY). With the market at all-time highs you may be a bit scared that you’re buying the top. After all, we’ve gone up a long way over the past five years and knowing your luck right after you jump in the market will inevitably plummet. It’s Murphy’s law! While I doubt a crash is imminent, that’s always the fear when we put a whole bunch of money in the market all at once at the same price.
A safer approach would be to invest the $10K over time – which will in turn mean you are investing at different prices. If you put in $1K each month for the next ten months then you will be buying more shares of the SPY at different prices each time. With this approach your view of a market crash would shift from negative to positive. Rather than being a painful development it would actually be an opportunity to buy shares at lower prices that month thereby lowering your average cost and allowing you to make money quicker on the next market advance.
When developing your trading plan remember the many faces of diversification and apply them accordingly.
Tyler Craig, CMT
Rich Dad Education Elite Training Instructor
March 14, 2013Posted by on
Much ink has been spilled over risk and money management. Given its lofty perch atop the hierarchy of essential trading principles it certainly merits a trader’s attention. This is why it’s a recurring topic within the Rich Dad Education Elite Training courses. Unfortunately many misguided participants ignore it to their own peril. While there are a plethora of useful phrases on the subject, one of my favorite is the following:
Never lose enough in a day to ruin your week. Never lose enough in a week to ruin your month. Never lose enough in a month to ruin your year.
It’s as if all traders have a loss spigot attached to their trading accounts. While the removal of the dreaded spigot is out of the question, traders do have some control over its size and the speed at which money flows from it. Sometimes I meet traders whose loss spigot looks like an open fire hydrant. The rate of loss is large and fast and if they don’t fix the plumbing ASAP they’re all but guaranteed a short trading career. For others it’s a slow and steady drip. Nothing too harmful in the short term, but like carbon monoxide it can be a silent killer in the long run.
The dual mandate of risk management is to insulate oneself from account crippling losses while still enabling the capture of profits. Put another way your rules shouldn’t be so suffocating as to hinder your ability to gain adequate profits. I want a set of rules that would make it difficult for even a kamikaze trader to blow up their account. If it insulates him from losses, surely it will protect a trader such as myself.
In order to limit the losses on any given day, week, or month most traders adopt loss limits. After losing a certain amount they simply stop entering new trades or taking on additional risk until the start of the next time period. The idea of course is to avoid compounding losses and making a bad day, week, or month, worse.
While there are a variety of methods you could use to arrive at the ideal loss limit amount, one simple way to start is by identifying how much you can afford to lose over these time frames and still bounce back by the end of the week, month, and year.
Tyler Craig, CMT
Rich Dad Education Elite Training Instructor
December 20, 2012Posted by on
The process of learning can be exhilarating and frustrating at the same time. For many students, the process of learning about technical analysis and trading is a fascinating time as their eyes open to a new world of knowledge and possibilities. It can also be frustrating as with this new knowledge come hundreds of terms, concepts, and strategies that not only must be learned, but learned very well if the student wants to go from conceptual learning to application and making money in the market.
Ask any trader who has successfully navigated these early months and years if the time and commitment was worth it and you will likely get a resounding yes. However, each trader likely had their moment of doubt at some early stage, that moment where they didn’t believe in themselves or thought the whole process was just too much for them to handle. What gets many traders to shake their head looking back is that it was the simplest of things that caused those early moments of doubt.
Perhaps the most common item that creates frustration in new traders is that actual placement of the order. While it will quickly become second nature to a trader once they practice and learn the terminology, it can be an extremely frustrating process for the new trader. What creates this frustration is not only the terminology, knowing what order to use at what time, but that they also have to learn to navigate the brokerage software.
If any of this feels familiar to you, be patient as in time this entire process will become second nature. In the meantime, if you are experiencing any frustration then utilize your virtual trading to practice placing orders and take advantage of any tutorials or customer service that your broker offers. Oftentimes a simple call to your broker and practicing a bit will allow you to get the essentials of your brokerage software down. After that, like with most things, knowledge will build on itself until the entire process becomes easy.
Common Order Types and Terms
One thing you will have to master, no matter what broker you choose to use, is the different order types available to traders. Learning these terms is essential if you want to maximize the choices at your disposal when placing an order. Many of these order types have advantages and disadvantages depending on the type of trade you are trying to make, so it is not only important to learn the terminology but also the context in which to place them.
Every investor and trader must check with his or her respective broker to learn how each of the following types of orders work on their particular system.
There are some traders that are scared to death of market orders. Other traders essentially use nothing but market orders. As with most things in trading, both sides are right depending on the risk tolerance and type of trader placing the trade.
A market order authorizes the broker to buy or sell a stock or option at the current quoted price when a trade reaches the trading floor.
Advantages – The primary benefit of a market order is that you will get it filled quickly. If you have to get into your trade immediately then a market order is the way to go.
Disadvantages – While you may get in immediately, you are not guaranteed to get the best price. What you pay when you buy or what you receive as payment when you sell is determined by the market’s next available price, which could be an unexpected price in some market conditions
Note of caution – Generally, it’s good practice to place market orders during market hours with stocks that have a lot of volume. The danger in placing an order after hours is that it goes up and you ending up having to pay a higher price
Limit orders take the guesswork out of how much you are going to pay for the stock or option. The guesswork is eliminated because you can literally limit the amount you will pay upon entering the trade. Your broker’s software will have a box where you can enter the price next to a limit order and this price is the maximum you will pay for that stock or option.
Advantages – The price the trader pays is limited so there will never be any unexpected surprises. Sellers also have the advantage of being able to set limits on the price at which they sell their stock or option contract.
Disadvantages– You are not guaranteed to get filled on your order. If the price of the stock or option moves past your limit price then there is a chance that you will get passed on the trade.
Note – For traders placing trades at night, you will likely be placing limit orders of one kind or another due to the potential of gaps the next day.
Think of a stop as your trigger into a trade. While most traders associate stops with exiting a trade they also can be used to enter a trade. Stop orders are simply instructions to your broker to execute a market order if the price of a stock trades beyond a specific price point. Buy stop orders are triggered once the stock climbs to a certain price and sell stops are triggered once a stock falls to a certain price.Stop orders can be useful in protecting your profits or limiting your losses.
The price has to go up to hit a buy stop
The price has to go down to hit a sell stop
A day order is an order that is good only for one trading day. It expires at the end of the trading day if it is not executed and can be any type of buy or sell order.
Good until Cancelled (GTC)
Where a day order will expire at the end of the trading day, a GTC order will remain open until it is cancelled or filled. Many brokers do put a maximum time on how long this type of order will remain open so check with your broker on the specifics.
One Cancels Other
This is an advanced order feature that is used when a profit target order and stop loss order exist simultaneously. If one of the orders is executed, this order type will tell the broker to cancel the other order type that is not hit.
These are some of the most common but far from the only options that will be staring at you on your order screen. The secret is to make sure you know what the order type means and what context it should be used in. Don’t be afraid to do a few dozen virtual trades with a particular order type if it is new to you.
July 7, 2012Posted by on
- Follow a proven trading plan: A trading plan that has been tested for consistent profits will help keep you in the profit zone and within the boundaries of success.
- The trend is our friend: Be aware of the trend. If a stock has an overall trend up, our probability for a downside trade will be reduced and vice versa. Remember everything we learn in trading is about probabilities to keep us profitable.
- If you are not sure, don’t trade: Regardless if the supporting indicators are telling us the probability for a trade is to place it, if we have reservations about the trade, don’t trade it. We need to trust our education, our trading system and don’t let our emotions play into the trade but if our gut questions the trade, don’t trade it. Sometimes the better trade is the one not placed.
- Cut losses and book our profits: Once our trade hits the loss percentage of our trading system, we need to cut our losses and get out. As successful traders, we are fully aware that we are going to lose and don’t get caught up in the individual losses. We understand the overall net profit and learn from our losses and move on. When our trade hits our profit margin, close the trade. A booked profit is money in our pockets where the glory of the profit on paper isn’t real until it hits our account. It is only theory until it is booked.
- Control our emotions: Sticking with a proven trading system will minimize our emotions. However, if at any time our emotions start to get in the way of our trading, take a break. Even if it is for weeks…get out and review our knowledge received from our education as well as our trading system so we can back on track. Emotional traders make mistakes that take us out of the profit zone and we need to stick with the system to grow our wealth month in month out in all markets.
- Trade money you don’t need: There is an emotional component to trading money we have committed to other things such as our safety net, buying a home, paying bills, etc. It makes it difficult for us as traders to trade money we have a hold on. At al times, we must only trade money that we do not have an emotional connection to with the full understanding if we lost it all, we certainly would not be happy but it would not change our lives. This helps us follow our trading system and keep us from emotionally trading.
- Continue education: We are meant to learn and expand our entire lives, we were born to grow. We need to remember that in trading this is no different. When we start to believe we have learned everything, the market will show us we don’t. Always continue education in trading, there is far too much we will never know to think we have made it.
Once we have the educational foundation, the system to follow to keep us in the boundaries of success and mentors to hold our hand as we grow, we are bound to achieve our financial goals trading. Maintain humility and continue to reach out to learn more and gain help from those further ahead trading than us and we will continue to enjoy the fruits of our labor. Happy trading!