If you ask a new trader what is the most important factor to take into consideration before putting on a new trade they may tell it’s how much money they think they can make.
However, there is even a more crucial step to factor in before hitting the buy button in your brokerage account. No matter how much money you think you can make, knowing the exact dollar amount of what you’re willing to risk is the first step from going from an average trader to a disciplined and profitable trader.
Determining The “I’m Wrong Level”
Applying proper risk management techniques is not only important for short-term traders, but is important for longer-term investors too. A shorter-term trader can place an appropriate stop loss under a key support level like the 50-day exponential moving average or the bottom of an uptrending channel. While a longer-term investor can use a reward/risk ratio step up to determine the “I’m wrong level”, or stop loss. If you’re expecting a 20% gain in shares of XYZ, a stop loss 10% under the current price would give you a reward/risk ratio of 2:1.
Stop Loss Alternative
Options give both traders and investors an alternative choose to a stop loss. The explosion of the options market in recent years has led to short duration weekly options and LEAPS that don’t expire for over two years.
Going back to knowing exactly what your dollar amount risk is for a stop loss, you can instead implement an options strategy that can offer the same upside potential in a desired time frame. For example, if you think XYZ (currently trading at $25.00 in January) can rise 20% to $30.00 by July, you could instead purchase 4 July $25/$30 call spreads for a $1.25 debit. This would result in the same dollar amount risk on 200 shares using a stop loss at $22.50 without the possibility of being shaken out on intermediate term volatility.
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Learn more about Warren’s option advisory service here.
