Risk Management - Rules Based Trading Part 1 | OptionsANIMAL

Risk Management – Rules Based Trading Part 1

August 3, 2011 / Emilu Bailes

“I work HARD for the money!” So, it’s no surprise that emotions get involved when we put our hard-earned money to work in the stock market.

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Image by leff via Flickr

I’ve heard that investing/trading is all about human psychology. I’ve also heard that the disciplined trader MUST be able to take action without allowing emotions to rule their decisions.  Can that be done? How?!

One way to reduce the influence of emotions on our trading decisions is to develop rules to guide our actions.  There are some basic areas of consideration when contemplating trading rules.  I like to start with the category of Risk Management.

Every investor would do well to set up some rules that will protect their capital investment.  Traders who only enter long or short stock positions are generally familiar with the use of Stop Losses.  And, each person must decide where to place the stop loss.  When you take an 8% loss on a position,  it will require a gain of 8.7% to get back to break even.  A loss of 20% will require a gain of 25% to break even.  A loss of 50% requires a gain of 100%. And, so on.  If we are to “keep our losses small” we must develop rules to help us in this regard.

How would an Options Trader develop rules to keep the losses small?  We have more tools in our bag of resources than the long stock only investor, to help us develop rules to protect ourselves.  There may be opportunities for us to reduce our overall cost basis in the long stock position by selling options against the stock.  And, there are protective options instruments that make wonderful risk-management tools.  Not only do we have an advantage in individual options instruments, but we may learn how to apply various spread trades to the basic position for protection and/or cost basis reduction. The key in knowing when and how to use the tools is in the education and on-the-job-training (experience.)

Applying proper Risk Management is the first step in developing sound investment rules.  I often repeat my fondest trading quote to students at OptionsANIMAL: “Manage your RISK. The profits will take care of themselves!”

Emilu Bailes
OptionsANIMAL Instructor

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