Maximum Loss Allowance (MLA)

I was trying to come up with the single most important rule that applies to every single trade entered and I kept coming back to the Maximum Loss Allowance, (MLA) which amounts to risk management.

I figured this one out very early on, I have an MLA for every trade. In my case I picked a conservative 2% of portfolio value. I've seen as high as 5% with 3% being normal. Having said that I didn't follow it every time and those times, generally, resulted in single trade losses in the hundreds of dollars. In one case in particular I had to chase the price down just to get rid of the stock at somewhere near a $400 loss, 8% overall. Small losses compared to some that I have been told about though.

The reason this is so important is many fold. It is involved in determining the position size (number of shares) the stop setting (price to sell at if the price drops), the target size (expected change in price), and it tells you what your worst case scenario is.

As I started with $5000 my MLA was $100 which now becomes my guide as I am willing to risk $100 for any given trade. This is a maximum though, I have used $50 if the price looks like it is a good position to move quickly and I want to cut my potential loss short if I am wrong.

Position : for a stock priced around $20 I would expect that a stop at $19 (purchase price less $1) might be appropriate. Therefore $100/$1 per share = 100 shares or 1 lot (the lot is a just a term for shares in groups or "lots" of 100 shares, like buying eggs by the dozen). I am using 100 shares or 1 lot for almost all of my trades so any examples will assume that Position size.

The Stop Setting is really aimed at safety at this point so it is referred to as a Stop Loss. Once the price has moved to a point where I can move the stop up into the money (profit if stopped out) then the game becomes more interesting as the stop gets set to maximize profits should the stock tumble or leave enough room for the price to continue past the initial target. It's no longer considered a stop loss so much as a profit protection after this point.

Target size: The potential profit or target needs to be greater than my MLA by 2 or 3 times. For a $100 MLA and 100 shares the stock should be expected to have the potential to move for at least $3 per share. I have charted out a number of stocks and in the chart name, upon saving the chart, I put the expected movement range. If it is less than $2 I won't generally consider it ready to trade. Much less than that and the price has a good chance of not even making it high enough for my stop to net any profit.

Worst Case Scenario: I always fall back to this when figuring trades. I have a column on my spreadsheet that I track my portfolio on that is takes my current stop settings, commissions and purchase prices and calculates my Profit / Loss based on the worst case scenario as if all my stocks tumble at the same time. This number is important as it is the real bill of health for me. I can spin profit numbers...in fact I was over 8% in my second week...but had everything gone sour I would have been around (-5%).

I had opportunity to have a Stop triggered today. I had moved the stop setting twice so my loss was limited to $44.90. like so many times a stop gets triggered it seemed as though the price reached down just for me as the lowest price for the day was my stop price setting. I couldn't have told you that would happen even had I been watching it so I would not have moved it anyway.