Another very common mistake traders make is that they don’t consider the fact that not going down is as important as going up. Often, traders will jump into a trade without looking at alternative ways to play the same move but do it with more upside and less downside. Essentially, they will take on undo amounts of risk. Later in this guide we will go through how to set a predetermined amount of risk in each trade. By using that approach we can guarantee our downside stays at an amount we are comfortable with which is much better that being in a trade that could be a bottomless pit.
For example, lets go back to an example stock, XYZ, that was trading at $50. You jumped in for 100 shares at $5000. That stock could theoretically go to $0. You set your maximum risk target at $1 below its current price at $49 for a total risk of $100. Your profit target was a $5 increase to $55.
Using the earlier scenario, we watched the stock go from $50 up to $53 before correcting and dropping below $40, say to $38. If you were able to stick to your plan, you’d have gotten out around $49 and lost $100. But the reason you may have broken your rule and held it down to $40 was because you believed it was going to go up. You wanted to be able to hold it through the drawdown so you could take advantage of the subsequent rally back up beyond your profit target but your risk plan wouldn’t let you. And rightly so.
The result is that the only way you could have stayed in for the payoff is if you had made the common mistake and not gotten out at your max loss target or if you had taken on undo risk from the beginning. The risk you would have taken would realistically be similar to the scenario we illustrated earlier that would have cost you $1000.
The common mistake people make in this situation is to not consider buying a call option. That would give you the right, but not the obligation to buy the stock at a future date at an agreed upon price. If you bought a monthly option with a strike price at $52 with a $1 premium, you could cap your risk at $100 ($1 premium x 100 shares and your original max risk target) with zero chance your downside would increase. In addition, you could watch the stock go down to $40 without putting yourself in an uncomfortable position that may cause you to break your rule. Why feel uncomfortable when you know with absolute certainty that your downside will never go over the $100 you set before you entered the trade.
Now you can sit back and watch XYZ weather the broader market churn with confidence that you will be able to get as much upside as it will offer with only as much downside as you determined was acceptable. Your trade expects the market to rise and the more it rises the more money you will make.
If eliminating uncontrolled risk doesn’t reduce your stress, I don’t know what will.
Keep learning and trade wisely,
Market Wealth Daily