Managing Risk

In a volatile unpredictable stock market, an investor must ask himself or herself "what could go wrong" before every trade. As the old cliche goes, "the devil is in the details." If you enter a bad trade with a leveraged ETF or a speculative stock, the price of the stock could drop 25-50% in three days waiting time before the stock trade settles.

If you invested $10,000 in what you thought was a sure thing, and you lose 30% on the trade, you are down $3,000. What if this happens multiple times? You could lose $9,000 more or less on just three bad trades.

I also have real examples to prove this from the stock market of September-October 2011. ERX, the triple energy ETF, was selling in the $44 range around the middle of September. It was down almost 50% from its high of $85. It seemed like the bottom was somewhere in the low 40s. Then, believe it or not, the stock dropped to $30 per share by September 30. If you had bought it around $44, you would have lost over 30% of your money in two weeks.

Then, for a second example, I'll turn to TVIX, the double VIX volatility ETF. By the end of September, it looked like the whole world was heading into a recession. The respected ECRI even predicted a recession for the U.S. for certain around this time. TVIX jumped up to $100 per share on the first trading day of October. What if you had bought $10,000 worth when TVIX was selling for $100? The stock was selling for $75 per share just three days later. You would have lost $2,500 in less than a week on a trade that seemed like a sure thing at the end of September.

My advice is to limit trades to $2,000 unless you have money to burn. If you make 30%, that is $600, and you should take your profit while you have it. If you lose 30%, it is only $600 rather than thousands of dollars. Even the best traders may only be right 2/3 of the time. If you make 48 trades per year at a 66.7% win rate with $600 gained or lost on each trade, you will be able to keep the $600 on 16 of those trades. The other 32 trades will cancel each other out. $600 times the net 16 trades adds up to $9,600 per year that you could make with just $2,000 of investment money that you keep cycling throughout the year.