D.R. Barton, Jr. of Trader's U: Joe's Loss Is Your Gain Controlling the Downside

Joe's Loss Is Your Gain: Controlling the Downside
by D.R. Barton, Jr.

President, Trader’s U

"Big losses continue to haunt us; nice profits are soon forgotten." ~ Shakespeare's Julius Caesar (liberally paraphrased by DRB)

I wasn't worried about Joe. He had the money to lose; but I could tell by his tone that the phone call wasn't about the money. There was fear in the voice on the other end of the line.

"How long have you been in the position?" I asked.

"It started out as a day trade in that semiconductor stock, Rambus," Joe replied. "But it dropped big on me that day and I just stayed in overnight, hoping it would come back up the following day. Then it was down the next day, and I just knew it that it would move up again. That was four weeks ago."

$320,000 is a lot of money to lose in four weeks. Fortunately, it was a relatively small chunk of Joe's net worth.

Joe got into the trade on a rumor that the chipmaker was going to make a big announcement. He was thinking about the big bucks he would make by being on the right side of some good news. But the news never came. And when the semiconductor sector took a big hit in early 2001, Joe's stock was cut in half in a matter of weeks.

While Joe had several miscues in this trade, the biggest mistake that he made was getting his priorities backward. He put his zeal for profits ahead of the need to protect his equity.

Let's use the tuition that Joe paid - and learn how you and I can leave the rookie mistakes behind and adopt the mentality of elite traders.

Here's how to make safeguarding our cash the number one concern BEFORE we enter a trade or investment...

Controlling Risk: Every Trader's Top Priority

I've had the pleasure of trading with and learning from some incredible traders. I also get to teach workshops where I hear from traders and investors of all experience and skill levels.

One difference that is always striking to me is between what I hear the pros talk about and what newer traders think.

When an experienced trader looks at any trading opportunity, the first thing he or she asks is, "Where will I get out if I'm wrong?"

In contrast, those new to the game are often lured to trading by the idea of big profits. A typical question asked by a new trader is this, "How much can I make if this works?"

Top traders are obsessed with controlling their risk and preserving their capital. This is their TOP PRIORITY.

The single biggest mistake a trader or investor can make is to hold onto a loser and give it a chance to grow beyond your intentions.

We hold onto a day trade loss and it turns into an overnight trade...

The overnight trade turns into a bigger, intermediate-term swing trade loss.

Then the trade that started out as a "little loss that came along one morning" turns into an unintended part of your core portfolio. Oh yeah - this "little addition" carries along with it a loss that is chewing up 10 or 20 percent (or more) of your equity. And it's still growing.

These are the type of trades that destroy accounts and end traders' careers before they even get started. As Shakespeare put it, these trades are "the evil that men [and women] do." And they sure haunt us for a long time.

But there is a better way - and it starts with your mind.

Think About Risk First and Reward Second

Top traders know that this game we call trading and investing is pretty simple, from a statistical viewpoint. Big moves do come along. Our goal, whether we are day trading or making long-term investments, is to be on the right side of those moves. And if we happen to get caught on the wrong side of the move - WE GET OUT! No questions. No hesitation.

Investment U has long been an advocate of using stops when entering trades. This is a great way to think about limiting risk. When you use a 25% trailing stop, you know precisely what your risk is before you enter the trade.

How You Can Use "Risk Control Thinking" In Your Trading

1. Before you decide to use any trading system or newsletter recommendation, make sure that there are explicit price levels that serve as the "get out if we're wrong" point for each trading signal or investment recommendation. If these "stop loss" points are not provided, find another system or advisor.

2. Work on changing your thought process. Everyone gets excited about the potential for big profits. But the folks that stick around for the long term think about "risk control" first and then "size of reward" second. Start to look at every trade or investment opportunity by first asking, "When will I get out if I'm wrong?" This applies equally to day trading, long-term investing, real estate projects or business ventures.

3. Once you know the "worst case" loss level (your stop loss), determine the size of your position. As a rule of thumb, do not risk more than 1% of your equity on any one trading or investing idea. When you are just starting out, trade even smaller size (one-quarter to one-half of a percent). As you gain expertise in a trading or investing strategy, you can increase this amount if the strategy or system is very successful, but not above a maximum of 2% of your equity.

4. Finally, don't forget about the reward side of the trade! Once you know the amount you are going to risk, make a reasonable estimate of the reward you could receive if this trade or investment works our well. DO NOT TAKE THE TRADE if the reward-to-risk ratio is less than 2:1. For most trading time frames that are longer than a few days, look for reward-to-risk ratios that are 3:1 or more.While it will be hard at first, try to set aside that warm feeling you get from thinking about the potential profits from a trade. Think first about managing the risk. Then (and only then) are you ready to look at the reward side of the equation. Dream big dreams, but keep your feet firmly planted on the ground.

Great trading,

D.R.