Diversification and Risk Management

Paying attention to risk is of upmost importance in trading. You have to ensure you won’t take a
drawdown above your psychological uncle point, for most traders this is 30%, after a 30% drawdown
it becomes mentally hard to continue with the same method. Also smart risk management ensures
your account won’t take a big hit if any one trade goes sour. Every now and then you will take a large
loss, this is part and parcel of trading, and something every trader has to deal with.
The first thing you want to decide is how much of your account you want to place in each trade. This
is a function of your risk tolerance and the maximum amount of positions you will allow. Ideally you
will place between 10-30% of your account in each trade. For example if you had a $10,000 account,
you may wish to buy $2,000 stock and short $2,000 at a time. With 2:1 overnight margin, this will
allow you to have a maximum of 5 pair trades open (5 x 4,000 = 20,000).
Next, you want a diversified portfolio of pairs, look for opportunities in as many markets as possible,
if you are just trading stocks, trade companies from a variety of industries. Even better would be to
trade multiple asset classes, stocks, futures, options and forex. Of course you will need more trading
capital and trading experience to trade multiple markets, this is something you can work towards.
You have to be careful with what stocks you trade, unlike with futures and forex which are large,
liquid instruments, some stocks present much greater risks. For example a large blue chip company
like Walmart (WMT) has significantly less risk inherent than say a small cap biotechnology company
traded on the NASDAQ which doesn’t have any revenue and trades only 50,000 shares per day, you
shouldn’t short stocks like this. Where possible, stick to the largest and most liquid stocks only.
When trading derivatives, use a % of your account position sizing rule, don’t over leverage your
account, the volatility in your trading account will become unbearable. The first goal of any
investment program is to preserve your capital, next is to reduce account volatility then your aim to
grow your capital above the risk-free rate offered in bonds. Focus on not exposing your account to
great risks and the growth will come naturally. Good trading is all about being defensive,
conservative and taking calculated risks.
Finally, be careful of the news surrounding stocks when trading. Don’t place a trade several weeks
before an earnings announcement, or make sure you don’t have a position during the
announcement, because if a company surprises on delivered earnings compared to what analysts
and market expected, the stock price can and often does move large amounts. Use yahoo finance
and earnings.com to check for stock news and upcoming earnings announcement dates.