Cooking Basics: A review of trading risk*

*This blog is approved for beginning stock market chefs.

It’s a well-known saying that money makes money, but how much money do you really need to make money? That’s a tough one to answer but perhaps we can gain some perspective on it by reframing it in more concrete terms such as: How difficult is it to make, say, $100 on a trade given a specific investment amount?

Now there’s many ways we can make our hundred bucks in the stock market. We can buy bonds, futures, stocks, or options and other derivatives. Since futures and bonds are outside the scope of my blog (at this time), we’ll be focusing on the other two—stocks and options.

As we shall see, the real reason that money makes money is because the larger your investment capital, the lower your trading risk. Money managers know that lower-risk trades are preferred, but lower risk usually comes with lower returns. There’s no such thing as a free lunch!

Everyone has his or her own comfort level on the risk/reward scale, and it’s up to you to know yours. If you’re not quite sure, the following table might help you decide how to position your trades.

Initially, I was going to lump both the stock and options discussions together in one blog, but I realized it was going to be too much so I’m splitting them up into two articles. Today, we’ll be looking at the trading risk profile for stocks.

Trading Table for Stocks
Below is a table that represents the trading statistics given a desired fixed outcome of $100 per trade. Yes, I know it seems obvious that the larger your trading capital, the lower your trade risk, but I bet many people don’t actually realize how much of a risk they’re taking on by using smaller trading amounts. Let’s take a look at the actual numbers:

Trade Risk Table-Stocks 12-23-09

The table shows that in order to make $100 on a $500 investment, you’ll need the stock to move 20% which is also the amount of investment risk that you’re be taking on. Are you comfortable with that?

Compare this with trying to make $100 with a $5000 investment. Here, the stock only needs to move 2% to attain your desired return.

What do you think is an easier goal to attain, a 2% stock move or a 20% stock move? If you can answer this correctly, you have all the knowledge you need to be a day-trader. Successful day-traders know that they can make significant amounts (generally $50-$200 per trade) on very small stock moves. In day-trading parlance this is known as scalping.

But I digress.  The point is that to make money on a small move requires a big investment. My day-trading teacher (way back when!) insisted that one should start with at least $50,000 in trading capital—any less and you risk losing all of it before they you the hang of day-trading. (I got out because I found after two months of paper trading that I didn’t have the stomach for it and couldn’t imagine putting my own money on the table.)

All or none?
The real question that capital-limited traders need to ask themselves is this: Should I risk all of my investment capital on one trade or spread it around among several?

Again, the answer to this isn’t cut and dried. I say that if you have less than $500, risk it all on one good trade until you can build up your trading account. The caveat here is that you must be absolutely diligent in setting a tight stop/loss, not risking more than 5% and going for a 20% gain may be an unreasonable goal except in violently trending markets. If you set a looser stop/loss and incur a string of losses, you could be forced out of the game in no time.

The big, bad brokerage fees
The numbers in the above table do not include trading commissions or other fees, and this is something that those of you with small trading accounts need to consider. If your broker charges you $20 per trade and you want to net $100 on a $500 investment, you’ll need the stock to move 28% instead of 20% (you’ll need $40 extra to cover the buy and the sell commissions). I know that TradeStation and Interactive Brokers (I have no affiliation with either one) offer lower commissions than most of the other popular online brokers, but do your own research and go with the one you feel most comfortable with.

Tomorrow I’ll do the same analysis for options which isn’t nearly as straightforward. Beginning options traders especially may want to tune into this one!

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