Rule #1: Diversify Your Trading Capital Allocation
If you have a huge percentage of your total trading capital allocated to just one or two stocks, options, etc., if one or both of those positions falls, your entire trading account is compromised. If, however, you have at least four or more holdings in your trading portfolio at any given time — and if those holdings each contain an equal percentage of trading capital — then any decline in one or two stocks can easily be absorbed.
Rule #2: Set a Price Target Before You Enter the Trade
Whenever you enter a trade, you usually are expecting that your stock or option position will rise, but how much of a rise are you expecting and what kind of gain are you prepared to take? These are questions only you can answer for yourself, but a general rule is not to get too greedy. If you set a price target in the neighborhood of 8% to 10% above your initial buy price, and your position then hits that target, you can either sell the position and bank profits, or you can take at least some of your gains off the table and let the rest ride.
Rule #3: Set a Stop Loss on Every Trade
The flip side of setting price targets is setting stop losses. By placing a stop loss on all of your trading positions, you will ensure that you never take a big loss in any one position. Like price targets, the exact point at which you place your stop losses is a question only you can answer, but a good rule of thumb is to never let a position fall more than about 5% to 10% before you sell.
Rule #4: Never Chase a Loser
Another rule that goes hand in hand with setting stop losses is to never chase a loser. This serious mistake can be a real killer for traders, as it locks up the capital originally invested in the position, then locks up more capital as that position is purchased on the way down. The simple fact here is that the sooner you cut a loss, the sooner you can make up the loss.
Rule #5: Stick to Your Strategy
There are all kinds of trading strategies out there. Some are very aggressive, swinging for the fences on every trade, while other more conservative strategies try to hit singles and doubles on a consistent basis. Both kinds of strategies can be successful, and there are many styles of trading that can work.
However, one thing that usually doesn’t work is to begin trading with a certain strategy and then abandon the principles of that strategy too early. Here the old adage “don’t change horses in midstream” should be kept in mind. If you’re trading according to a specific strategy, at least follow that strategy’s tenets all the way. Doing so will allow you to objectively assess whether that particular approach is right for you.
This article originally appeared on Traders Reserve.