Many people who want to learn how to trade the stock market ask me “please teach me a trading system that does not lose money when the market goes down!”
The idea that there is a system for trading the stock market with which you never lose money or will always win, is a myth that is touted by snake oil salesmen. No trade offers a 100% guarantee. The market is volatile by nature, it is in a constant state of change and flux so what you must do is manage your risks. Markets are constantly moving up and down and you must be prepared for that. It is easy to get into a trade but it can be difficult to get out of one. Managing risk is one of the most important things a trader can do because no one ever gets every trade right. This does not guarantee that you will not lose money but it will limit your loses in the event of a market pullback. If your stock drops 50% you need to make 100% to breakeven so minimizing loses is key.
When you buy a stock there are three things that affect the price – the company, the industry and the market. So how do you manage that risk? Here are a few ways:
This may sound basic but it is valid none the less – Diversification. By diversifying your portfolio into different sectors and industries this can protect you from industry and company risk. If one company or sector gets hit hard you have others doing well that will balance that. Certain sectors do well during different times in the business cycle. Think of it like a summer day in Ireland, you never know if it is going to rain or shine so you prepare for both. This is how you should look at diversification.
Another way to protect your risk is by putting in a “stop loss”. A stop loss is an order you can put into a trading platform to limit your downside risk. It is a sell order on a stock or position you own in your brokerage account. This is not guaranteed, as a stock can gap down and go right through your stop loss but the idea is to put a line in the sand. Many investors do not want to sell at a loss as this means they have to admit that they are wrong but I would rather admit to being wrong and limit my loss than allow my pride cause me to lose a large amount of my investment.
Finally you can buy insurance on your portfolio or stock. This insurance is in the form of a put option which you buy, that will insure a price by a certain date on either a stock or the market. This of course will cost you money but think of it as the cost of doing business. You have to be careful though because as markets begin to drop, volatility in the market will rise and this will increase the price of put options making your insurance more expensive than you budgeted for. You can also insure your portfolio by buying a reverse ETF on a market index. ETF is an exchange traded fund it is a fund that trades on an exchange like a stock. ETF’s have different trading strategies one of which includes shorting the market. You must ensure that you buy the right ETF, one that matches your portfolio and also note that some ETF’s are leveraged.
No matter what the market situation is you must know how to manage your risk. Over the long term you will make way more than you lose in any one trade by managing your risk. So when you start trading prepare yourself psychologically for not getting every trade right. Remember investing in the market is a marathon not a sprint.