A Practical Risk Management System for Stock Trading

Successful people don’t wish for success; they decide to pursue it. And to pursue it effectively, they need a system.

How to Fail at Almost Everything and Still Win Big: Kind of the Story of My Life” by Scott Adams

If you’d like to start trading stocks, you need a system for managing risk that you can adhere to. In this post I present such a system, where the emphasis is on defining your risk before you buy a stock.

The system has 5 elements you’ll need to track (ideally in a spreadsheet):

  1. Buy price
  2. Stop price
  3. Target price
  4. Risk/Reward
  5. Number of shares

Consider this post a practical example for one type of risk management system in stock trading. Whether your account size is $500, $1000, or much more, this system can be of benefit.

This post begins after you’ve picked a stock you’d like to buy, and are deciding on if you should take the trade, and how much capital to allocate. I therefore exclude discussion of stock picking strategies, fundamental analysis, and technical analysis strategies.

Buy price

Let’s say you are considering buying shares of Starbucks (SBUX).

Start by determining the Buy price.

For purposes of this example, you will buy Starbucks at the current market price. Starbucks last traded at $78.87 per share. So let’s assume your Buy price will be $79.

Stop price

Next, determine the Stop price.

This is the price below your Buy price, that if Starbucks trades at this price, you’ll immediately sell all your shares to close your position. No exceptions. This step is critical to protect your total account from a major loss.

One technique to determine your Stop price is the 8% rule. A rule popularized by William O’Neil in his seminal investing book, “How to Make Money in Stocks: A Winning System in Good Times and Bad“. The 8% rule states that if the stock falls 8% below your Buy price, you will sell immediately.

Thus, with a $79 buy price, the 8% rule sets our Stop price to $72.68. So if Starbucks trades down to $72.68, you will sell your shares.

Another technique to determine your Stop price is to use technical analysis. Here is a basic 6 month daily line chart:

starbucks-6months

After a significant price drop, the stock appears to have stabilized (found support) around $73. Therefore you could set your Stop price just below that level, at $72.87 (to give the trade some wiggle room in case the price drops down to $73 and bounces up from there).

You can also combine the 8% rule with technical analysis. Say you determined the technical support level for Starbucks was at $70. By setting that as your stop price, you are now risking 11.4% (9/79) on this trade, which may be too much risk if you are adhering to the 8% rule.

Target price

The Target price is the price you’ve determined (using fundamental and/or technical analysis) the stock can appreciate to. It’s the price that you’d be willing to sell all your shares in order to lock in profits for the trade.

Like the Stop price, there are many techniques to determine the Target price.

One technique is to use technical analysis. Using the chart above, we could set our Target price to $90, which is about the price the stock was trading at the end of April 2024 before the large price drop.

Risk/Reward

Reviewing our numbers:

Buy$79
Stop$72.83
Target$90
Risk$6.17
Reward$11
Risk/Reward Ratio1.78

The Risk of this trade is defined as the Buy price ($79) – the Stop price ($72.83). So if we bought 1 share, and are wrong, we could lose about $6.17.

The Reward of this trade is defined as our Target price ($90) – the Buy price ($79), $11. So if we bought 1 share, and the stock reaches our target, we could potentially make $11.

By dividing the Reward ($11) by the Risk ($6.17), we get a Risk/Reward ratio of 1.78. In other words, for every $1 we risk, we hope to earn about $1.78.

The Risk/Reward ratio can help answer the question on whether this is a trade to take or avoid.

Ideally, you’d want to look for for 2:1 (or better) trades, and avoid 1:1 trades. So for every $1 at risk, the trade could potentially reward $2, $3, $4, etc.

Why is this important? Say you did 100 trades a year, what percentage of those trades are going to be winners (reach your target) versus losers (reach your stop)? Do you think it’s more likely that over 50% of your trades will be winners, or 20-40% of your trades will be winners?

By taking trades that have 2:1, 3:1, or higher risk/reward ratios, you can still be profitable even if you’re wrong more often than you are right.

win-rate-table
Win Rate table from Trade Brigade

Number of shares

After reviewing the Risk/Reward ratio, you’ve decided to do this Starbucks trade. How many shares should you buy?

Enter the 2% rule. The 2% rule states that you will not risk more than 2% of your account size on any single trade.

Let’s assume your total account size is $1000, this means the most you should risk on this Starbucks trade is $20.

Since our risk for this trade was $6.17 per share (Buy price $79 – Stop price $72.83), we can therefore purchase up to 3 shares. And if we are wrong, and get stopped out, our total account takes at most a $20 loss.