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CATEGORY Basics

Crash Trade: How to Prep for the Big One



May 17, 2017

It was only a matter of time.

The Dow Jones Industrials plunged 300 points in a day. People panicked. Investors leapt from trades. Stop losses were taken out. Fear gripped the markets, sending the Dow well under its 50-day moving average support line.

All on rumors that President Donald Trump could be impeached at the time.

Many learned the lesson the hard way buying markets at all-time highs, blissfully unaware that at some point it could all come crashing down. Many weren’t prepared. Others didn’t have stops in place at all.

But as always -- that’s always the wrong way to trade.

In fact, you must manage your money well, or you can lose it all.

Trading without a plan is as good as an idea as driving blind. Money management defines your risk. It also gives you a way to set aside a set dollar figure per trade each and every time. We don’t know if any next trade will be a winner or a loser.

Why bet the farm when you can’t afford to lose the farm?

None of us can afford to do that…

If I knew that 7 of my last 10 trades would be a winner, but I didn’t know which ones, how would I allocate my capital risk? To be safe, we’d allocate up to 5% max on each trade. This way, you control your risk without risking the farm.

Depending on whom you speak to, experts say to risk 1% to 3% of working capital on any one trade. The most I’d say is 5% max. If you have $50,000 in capital, maybe use $2,500. If you have a $5,000, account, maybe risk $500 to start out.

You can always work up. How much loss can you tolerate? Don’t use a % until you realize the $ amount it translates too. Once I know the $ equivalent, I can create a play plan. Also, define market factor risk now.

To prepare for another pullback, you need to think about exposing yourself to less risk if the volatility in the market is too high. Lower your capital risk and your stop loss if need be. Markets don’t go up or down in an orderly fashion.

Or, if it’s not money management destroying your portfolio, it’s the lack of a stop loss. As an investor, you should be familiar with a stop-loss, or the order given to a brokerage to sell a position once it drops by a certain amount or hits a certain level. 

With stocks, it’s always safe to use a stop loss of -25%, on average, in our opinion.

It's a safe, easy strategy that should be part of all portfolios.

If a trader bought a $20 stock and placed a -25% stop loss on the trade, the trade would be automatically exited if – and when – the stock hit $15 a share (25% of $20).

The most important lesson to learn is this -- a trader with no plan for action has already lost. Do you know when to exit on an up or down move? What stop losses or trailing stop losses do you have in place?

Know these things, and set a plan so you won’t run into “crash and burn” scenarios as often as those with no plan.

  • Know when to just walk away from a trade. Remember, stocks don’t just move up. They also come down. Lower expectations. Inexperienced traders expect to quit their day job and make a fast-paced, hot lifestyle out of trading. That’s not going to happen. No one ever became a brain surgeon or rocket scientist first year in. The same applies to trading. If you make a mistake, learn from it. Don’t repeat it.
  • Remove all emotion from your trading. That doesn’t mean you have to have ice flowing through your veins. It simply means you need to re-think your strategy.
  • Have money management techniques in place.
  • Have a stop loss and trailing stop loss strategy.

The market is not a sure thing. Be prepared.

 


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