Markets are having a tough time getting off the floor today. As corporate headlines regarding some of tech’s biggest names are pushing stocks lower. As fears of antitrust are hitting names like Apple, Amazon, Facebook, and Google.
That said, the focus remains the same: Risk Management.
You see, after my broker lost half of my portfolio during the financial crisis… I was forced to spring into action… and I had to teach myself how to transition from long-term, buy and hold investor to trader.
And mind you, I was in my 50s when I started this journey, and since then I’ve gone on to make over $2M in trading profits. I say that not to brag but to let you know what is possible if you put your mind to it.
Now, the only reason why I’m here today is because of my disciplined approach to trading. But believe me… it wasn’t always like this… I used to trade off the seat of my chair… jumping in and out of trades … without any rhyme or reason.
So what were my big changes to risk management that brought me to the path of profitability?
Well, tech stocks fell into correction territory today, as the Nasdaq-100 was dragged lower by Facebook (FB) and Alphabet (GOOGL).
In times like these… proper risk management is key.
Now, do you remember back in 2007 – 2009?
Well, I remember it vividly…
… I actually had a broker doing all my investing and trading at the time… little did I know, I lost 50% of my portfolio at the time.
It wasn’t until after my portfolio got destroyed that I decided to take matters into my own hands.
Fast forward to today, I like to be in total control of my risk… and I’m very risk averse. In other words, I don’t like to take on a lot of risk.
Now, when markets are crashing, the one thing you can do is get on the defensive, especially if you’re mainly focused on buying stocks…
There are actually multiple ways to manage your risk when markets are selling off, and we’re going to go over how you can potentially prevent your portfolio from getting damaged like mine was during the financial crisis.
Keeping A Set Risk Parameter
One way to properly manage your risk is stick to a set of rules and guidelines. For the most part, I don’t risk more than 2% of my portfolio in any one trade.
In other words, if you have a portfolio with $25K… a good rule of thumb is to never risk more than $500 per trade.
You see, when you have a set rule of not losing more than 2% of your portfolio in any one trade it makes things a lot easier.
For example, let’s say you buy 300 shares of a stock at $20 based on some type of analysis… and you stick with the 2% rule, and can only lose $400 in any one trade.
Well, you can set a stop-loss order at $18.75…
… if you want to get more specific, you can put a stop-limit order with a trigger price at $19, and a limit price at $18.70.
That means if the stock gets to $19… your order would become live, and if the stock falls to $18.70, you would get stopped out of your position and sell your shares.
When you have stops in place, it prevents you from trading on emotions.
I can’t tell you how many times traders have come to me after the fact… telling me they held onto a stock too long and just kept averaging down… until they lost too much of their portfolio, only to sell those shares.
Having stops and a set risk parameter is one of the easiest ways to manage your risk… using this golden rule of not risking more than 2% of my portfolio has helped me become a better trader over the years…
… as well as using trading plans to detail my entries, profit targets, and stop-loss areas.
Now, there’s another way to manage your risk, and that’s by using something known as beta.
Beta to Hedge Risk
Beta is used to compare stocks to the overall market… there’s a math formula behind it, but I won’t bore you with the details.
Basically, beta measures how a stock or exchange-traded fund (ETF) moves with the market. Now, when I saw the market here, we’re talking about the S&P 500 Index, or S&P 500 ETF (SPY).
It’s actually pretty simple.
The market has a beta of 1.
Now, if a stock has a beta of 1, that means it moves with the market… with more or less the same magnitude.
However, if a stock has a beta of say 1.50… that means it is thought to be 50% more volatile than the market.
For example, tech stocks generally have high betas because they’re a lot more volatile than the overall market and tend to experience large price swings.
Here’s a look at the Facebook’s beta in relation to the market.
Source: Yahoo Finance
In other words, FB is theoretically riskier to hold than the market… and if the market falls… FB will move with the market with a higher magnitude.
Keep in mind, beta is a lagging indicator and is based on historical performance and volatility.
However, it gives you a good idea of how exposed you are to the market.
So let’s say your portfolio has a beta of 2.
That means if the market drops 5%… your portfolio could drop by 10%.
Generally, your broker should provide you with your portfolio beta… if they don’t, make sure to ask their customer support so they can direct you to where to find that information.
Now, you’re probably wondering, “Well Petra, what happens if I’m long the market and my portfolio has a high beta?”
First, you can set a stop loss for your positions… that’s the easiest way.
Another way would be to try to structure your portfolio in a way where you’re not exposed to the market.
For example, there are some stocks and ETFs that you could use to hedge your portfolio… in the event of a market selloff.
You see, beta can also have a negative value.
What that means is if the market goes down… stocks with negative betas should go up. For example, check out AngloGold (AU).
As you can see, AU actually has a beta of -0.99. That means if the market goes down… AU should go up.
That said, if you’re buying stocks… be mindful of beta and whether you’re getting too heavy to one side. If you’re constantly buying stocks with high betas… try to balance it out with some stocks or ETFs with negative betas.
In other words, look for trades that move with the market… and stocks or ETFs that move in the opposite direction of the market.
For example, Jeff Bishop actually uses this approach. His portfolio actually has positions that move in the same direction as the market… and positions that move in the opposite direction of the market.
In other words, he’s not too heavy on either side. If markets crash… his portfolio remains in tact, and he’ll have some winners. If markets rise… he’ll have winners as well.
That said, make sure you have stop losses in place, cause it seems like this market could be in for a second leg lower.
Now, if you’re looking for trading lessons that could help you in this market environment, check out my 10 Must-Have Trading Tips.