The New Sell and Sell Short: How to Take Profits, Cut Losses, and Benefit from Price Declines, Expanded Second Edition

THE IRON TRIANGLE

The main purpose of using stops is to protect yourself from adverse moves by limiting your loss on a trade to a predetermined amount. The secondary purpose is to protect paper profits. With loss control the key purpose of stops, it is no wonder that setting stops is tightly linked with money management.

The process of risk control works in three steps:

1. Set a stop on the basis of chart analysis and then calculate the dollar risk per share by measuring the distance from the planned entry price to the stop level.

2. Use your money management rules to calculate the maximum amount you may risk on a trade and decide how much you will risk.

3. Divide the number of dollars in line 2 by the number of dollars in line 1 to find out how many shares you may trade.

I call this the Iron Triangle of risk control. One side is your risk per share, another your total permitted risk per trade. The third side, derived from the first two, gives you the maximum trade size.

Size, as the joke goes, does not matter. What matters is risk.

As a trader, you do not really trade IBM or EBAY or soybeans—you trade money and deal in risk. This is why you must set your position size on the basis of risk.

Compare buying 1,000 shares of a $20 stock and placing your stop at $17 to buying 2,000 shares of a $40 stock and placing your stop at $39. Even though the size and the cost of the second position is greater, the amount of risk is lower.

Let us review the three steps outlined above, ...