In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 5:

Create Risk Management Rules

Suppose you had a specially weighted coin that when flipped came up heads 55% of the time and tails 45% of the time.  You have a pot of $30,000 to wager on coin flips.   You can choose to bet as much or as little as you want on each flip.  The amount you wager is added to your pot if you correctly call the flip, or subtracted from your pot if you're wrong.  You can go on forever as long as you still have money in your pot.  Obviously you want to increase your pot as much as possible. Seems hard to lose with a weighted coin!

Now the game begins.  You wager $1000, and call heads (of course).  The coin lands on heads, you win, so you now have $31,000.   You wager $1000 again, call heads, coin lands on heads again, so you now have $32,000. Things are going your way, so next you wager $12000.  This time you lose, so you're down to $20,000.  No problem, you know the odds are in your favor, so you wager $12000 again.  Again you lose, so you are down to $8000.  This upsets you a bit, but you figure with a weighted coin there no way there could be 3 tails in a row.  So you wager the remaining $8000.  Unbelievably, you lose again, & you have nothing left.  Game over!

You sit there stunned, pondering how it is possible that you lost $30,000 when the odds were clearly in your favor.  The answer, of course, is that you used poor money management.  Favorable odds will play out over the long term, but not necessarily over the short term.  In order to let the odds play out, you have to risk a smaller percentage of your total pot. 

This coin flipping game is analogous to trading.  You start out with a fixed amount of cash in your trading account, and each trade is like a coin flip. 

Now suppose you have a $30,000 trading account.  You decide to buy 500 shares of a stock that's selling for $40/ share: that would cost $20,000.  Obviously $20,000 is too much to risk $30,000 trading account - this is why you should use a STOP LOSS.  So when you buy the stock, you instruct your broker to immediately sell if the stock goes to $39.  Thus you limit your risk to $500.  

The STOP LOSS is the basic building block of any Risk Mangement plan.  There can be much discussion as to what size to set your STOP LOSS, but there should be no discussion as to whether or not you should use a STOP LOSS.  Use a STOP LOSS or eventually you will wipe out your account.  Period. 

So here's your first Risk Management Rule.  Always use a STOP LOSS with every trade

A simple Risk Management plan consists of just 4 more Rules:

1. Maximum % of your account value you will lose per trade (determined by your STOP LOSS)
2. Maximum % of your account value you will lose per day
3. Maximum % of your account value you will lose per week
4. Maximum % of your account value you will lose per month

Here is an example of the Risk Management Rules:

1. Maximum I will lose per trade is 1% of my account
2. Maximum I will lose per day is 3% of my account
3. Maximum I will lose per week is 7% of my account
4. Maximum I will lose per month is 10% of my account

The % numbers I use above are only meant to be an example.  You will need to decide on the exact numbers you want to use.  Setting a good STOP LOSS for a particular stock or commodity is something of an art: a "tight" stop loss reduces risk per trade but can lead to getting stopped out too often. 

To illustrate the sample rules above, suppose you have a $30,000 trading account. Per Rule #1, the max you can lose per trade is 1%, or $300.  So you could buy 300 shares of a stock selling for $40/share, and set your STOP at $39.  Or you could buy 100 shares at $40/share and set your STOP at $37. Per Rule #2, the max you can lose per day is 3%, or $900. Once you have lost $900, you MUST have the discipline to quit trading for the rest of the day.  Now suppose you have lost $750 so far today - can you make a trade risking $300? NO!  Because if the trade went against you, you would exceed your $900 daily max loss.  Per Rule #3, the max you can lose per week is 7%, or $2100.  If you've lost this much and it's only Wednesday, you MUST have the discipline to quit trading for the rest of the week.  Per Rule #4, the max you can lose per month is 10%, or $3000 - you get the idea.

Create your own Risk Management Rules before you make even one trade. 

If you don't have the discipline to follow your Risk Management Rules, you may wish to purchase my "Bash-O-Matic Traders Helper".  This highly sophisicated, programable, electromechanical device is compatible with most PC's and mounts conveniently on your desk.  Once installed, a large hammer automatically hits the trader over the head as soon as it senses any Risk Management Rule has been violated.  To order yours, simply send $9999.99 cash to:  

Miracletech LLC
PO Box 123
Cayman Islands