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Monday, November 17, 2008

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Risk Management

The answer to the question, "Is Managing Risk Optional?", given by most people and certainly most traders and investors is "Absolutely not! Of course you must manage risk in order to potentially be successful," they say. And they are absolutely right! Why then do few traders and investors do a good job of managing risk?

Managing risk is an easy concept to embrace intellectually, but not emotionally. We all tend to want to risk too much on any given trade, or worse yet, we'll tend to have that "home run" mentality, always looking for that one great stock that will make us wealthy. We end up committing too much capital per trade which sets us up for a string of losers that could do serious damage to our account. We do this because we fail to comprehend that any system or method of trading will suffer losses from time to time, no matter how good the system or method - alas, the "Holy Grail of Trading" does not exist.

Another tendency that most of us have is to want to trade on a regular basis every day, and every week depending on our time horizon, without any regard to whether or not there are any good trade set-ups offered by the market. One of the most effective forms of risk management is to avoid trading when there are no potentially high probability set-ups available.

Is managing risk optional? No. For stock traders, following these two simple rules could potentially mean the difference between outstanding returns and unnecessary losses*:

Rule#1: Risk no more than 2% of your account on any one trade.
Rule#2: Be patient, be selective and wait for the good trades.

[Source: Risk Management in Trading, by Bill Poulos]

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