Can I Safely Invest In The Stock Market?

The question might also be ‘Can you safely trade in the stock market?’.

The answer is that there is no way to trade safely in the stock market, in the way that the word ‘safe’ is commonly thought of. Is it safe in the sense that it carries no risk? No. Absolutely not. All trading carries risk. However, there are degrees of safety. And a trader who understands risk, and manages risk well, has as safe a form of trading or investing as it is possible to have.

And it can be safe enough that stock trading can be a profitable venture.

SPY_Chart

Risk Must Be Controlled

So, how can you have risk and safety side-by-side? Just as in an industrial workplace, safety is achieved by having a complete understanding of the risk involved, and taking all steps to mitigate and control the risk.

Just like crossing the road, and a thousand other things in every day life which have some risk. Yet we learn to navigate them safely.

Risk management and trade management lies at the heart of successful trading. It is a huge factor in safety. The same principles apply to investing, although it is not so common for investors to operate with these principles.

Trading or Investing?

Investing and trading can really be considered the same thing. They have the same major objective, and far fewer differences than similarities.

The common objective, of course, is that both the trader and the investor hope to sell their stocks for a higher price than they paid to buy them. This is the truth of the trader who is selling short, who is still hoping to sell his staff at a price higher than he buys it for.

The largest difference would probably be the timeframe. And investor would tend to have a longer time frame view then a trader, although long-term traders could easily be considered to be investors.

The other main difference is in how a trade and investment is managed. And investor will tend to have a more hands-off approach. A trader will have a plan for managing his trade, whatever its timeframe. Or, at least a trader should have such a plan. Somebody trading without a trading plan has an exponentially higher probability of failure than the trader with a well defined plan.

So a main difference between trading and investment is how the trade or investment is managed. And a successful stock trader will have risk management and a solid trading plan which defines how his trade is managed. And risk management and trade management contribute a very large proportion of a traders success.

All Traders And Investors Should Control Risk

It would appear, then, that an investor would do well to adopt the approach of a trader, regardless of timeframe over which he plans to invest.

So trading and investing can be considered the same for the purposes of this article.

If risk is well understood, and well managed, then trading becomes relatively safe, in the sense that no single event in the stock market is going to wipe out your account. It becomes safe in the sense that the trader can endure the inevitable string of losses without so much damage. to his account that he cannot recover.

The art and science of trading has risk management as its primary requirement.

Risk Is The Only Thing We CAN Control

The first requirement in trading safety is to control and limit the amount that we risk, in dollar terms. In fact, this is the only thing in trading that we can control.

We cannot control what happens after we enter the trade, we cannot control whether we are able to exit with a profit or with a loss. But we can control when we exit, and thus control the amount that we risk.

Limiting Loss To A Maximum Dollar Amount

Traders do this by establishing a stop loss before they enter a trade. They then control their dollar risk by a simple calculation.

First, you decide on your maximum acceptable dollar loss. This should be defined by you in terms of a percentage of your total account. A prudent trader will risk no more than 1% of his account on any single trade. So, if your account is $10,000, then 1% of that is $100. So you ensure that you lose no more than $100 on any single trade. How do you do that?

Here’s a simple example:

Let’s say current stock price is 80.22 and we decide on 76.68 as a logical place for our stop — somewhere beneath market structure, but with room to avoid stop-hunting and enough room so that the typical day-to-day moves in our stock do not take us out of the position.

Our account size is $10,000 and we decide to risk only 1% on any trade. Our maximum dollar risk then is $100

If price moves down from our 80.22 entry price and reaches that stop at 76.68, we are down (80.22 – 76.68) = 3.54 points

Entry-Stop-Calculation We simply take our $100 max loss, and divide in by our points loss if the stop is hit
100/3.54 = 28 Entry-Stop-Calculation

So the maximum number of share we can trade is 28 shares.

Let’s work this back the other way to confirm our maximum dollar loss. After all, it is our money at stake and it is an important matter.

We would buy 28 shares at 80.22, for a total cost of $2246.16
If the stop is hit, we would sell 28 shares at $76.68. Total $2147.04
$2246.16 minus $2147.04 is our dollar loss, which is $99.12 Entry-Stop-Calculation

We have limited our loss and, at $99.12, we have contained it within our selected maximum risk number.

It should be noted that, on daily charts and larger, it is possible for a stock price to gap down, and jump past our stop loss. If the occurs, the potential dollar loss is larger than the maximum amount we decided upon.

Thankfully, this is a fairly rare occurrence, and it is just one of the risks associated with trading.

In order to control risk, your only remaining job now in this trade is to exit the trade if price reaches your stop loss price.

If you do not establish a stop loss and honor it when price gets there, you are effectively risking the whole dollar amount you have in the trade.

The following scenario happens again and again…

A trader has a position on with no defined stop loss. The trade turns the wrong way and, before you know it, the trader has a large open dollar loss. The trader is frozen in the headlights. He doesn’t want to take this large loss. He convinces himself that the trade will ‘come back’. He holds on and hopes and prays. But the market doesn’t care about anybody’s position. It does exactly what it wants to do, every time.

There is a high probability that price will continue in its current direction. If the direction if a trade has turned against you, it is prudent to assume that it will continue in that direction. In which case, you should get out,m and accept the loss. Because there is a strong possibility of a larger loss if you stay in the trade.

This has been the cause of major problems for countless traders, Ad it s the reason why you must always have a defined stop loss, and exit the moment that price reaches that point. You can do this by putting a stop order in the market, so that you have to take no further action.

This is an effective and efficient way to do it. There is usually a big benefit in removing yourself from the equation and having things happen automatically. But many traders are reluctant to have their stop orders in the market, because they are visible to others. The concern is that larger players may move price to ‘hunt stops’.

Two Broad Categories Of Risk

There are many sub-categories and sub-definitions of risk butt, broadly, our trade will incur risk which falls into two main categories. Trade risk, or business risk, and market risk.

Business risk refers to the risk that the individual business has some event which will negatively affect the price of its stock. This will only affect one trade.

Market risk is the risk that a large financial or geopolitical event effect causes a drop in the market.

If the market suffers a downturn or, even worse, a sustained bear market, then most stocks will be negatively affected pretty quickly. All stocks will be negatively affected eventually. This will potentially affect all the different trades that you have open

Which leads us to portfolio risk. Which is the combined risk of all your open trades. Just as you established a dollar risk for each individual trade, you must define an overall portfolio risk which is the combined dollar risk of every trade you have open.

For example, your trading plan might call for you to have a maximum of 8 to 10 trades open at any one time. If you have 10 trades open and each has a maximum risk of 1% of your account, your whole portfolio of 10 trades carries an open risk of 10% of your account.

Compare this to having no stop loss, where your portfolio risk is potentially every dollar you have invested.

These calculations must be well understood, and put into place as absolute rules which the trader will not break.

This subject is particularly relevant in the context of current market events. SPY fell almost 30% in 14 days. In the last week, we have seen the largest single day decline for the S&P500 and Dow Jones since the 87′ crash, and two circuit breaker halts at the exchange.

Here is the most recent chart of SPY again. Let this image inform your future trading — it’s a perfect instant visual demonstration of the necessity for a stop loss.

SPY_Chart

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See also:
What Successful Traders Know