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The Question Every Rich Trader Asks All the TimeBy Brian Hunt, editor in chief, Stansberry & AssociatesMonday, August 10, 2009 How much can I lose on this?
For the newer traders I've been writing to over the past few weeks (see my essays here and here), this is the greatest question in the world. It's the rich trader's mantra.
The people who always ask this question are consistent winners in the markets. The people who never ask it are consistent, eternal losers.
You see, the first thing most investors and traders ask themselves is, How big are the potential gains here? They get some hot tip from a cousin, a newsletter, or someone at work, then take a pile of money and throw it into a stock that could rise 200% in the next month. They focus on reward. They focus on that 200%.
Remember: Most traders lose money in the stock, options, and futures markets. You don't want to be anything like most traders. You want to focus on risk. You want the question above fresh in your mind... or better yet, taped to your computer screen somewhere.
In other words, you want to win by playing exceptional defense.
Focusing on risk and playing exceptional defense is what keeps the boogieman of trading away from you. That boogieman is something called the catastrophic loss.
A catastrophic loss is a huge losing trade that wipes out 33%... 50%... or even 99% of your money. It's the dot com stock so many folks were clobbered by in 2001. It's the bad condo deal they put together in 2006. It's the mining stocks they lost big on last year.
These sorts of losses can literally ruin your life. They can lead to divorce, late retirement, or so much stress it kills you.
You can use two super-simple trading tools to prevent the catastrophic loss.
One, is the stop loss. This is a predetermined point at which you will sell a position if it moves against you. It can be as little as 5% below your purchase price, a middle-of-the-road level of 25% below your purchase price, or even 50%. The beauty of the stop loss is that it is set before you buy. This gets your plan in stone. So you're not trying to decide what to do on the fly while you're stressed out.
Two, is something called position sizing. Position sizing is the part of your strategy that determines how much money you'll put into a given trade. If you practice smart position sizing – like never putting more than 4% or 5% of your money into any one given trade – you'll steer clear of horrible losses folks see when they go all-in and bet 50% of their money on one hot tip.
(If you're interested in really mastering position sizing, make sure to read Van Tharp's outstanding book Trade Your Way to Financial Freedom.)
So the next time a coworker, a stock promoter, a cousin, or a financial advisor tells you about their latest great stock idea or business, shoot 'em the magic question. Ask, How much can I lose? Watch their facial expression turn to complete confusion and surprise.
If the answer is A lot or I don't know, run away from the situation. If you can use the tools I just discussed to answer, Not much, but you can make a lot, you might have a fantastic trade on your hands.
And when you start finding those win-big, lose-little situations, regularly, you'll have a lifetime of trading success.
Good trading,
Brian Hunt
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