DO YOU KNOW?
The 3-5-7 Rule
In our Do or Did You Know? blogs we provide readers with useful information that generally is not realized by inexperienced investors. In Chapter 6 of our publication, When to Buy and When to Sell: Combining Easy Indicators, Charts, and Financial Astrology (available on Amazon), we discuss topics including risk management and profit taking.
Without the proper system, mindset, emotional control, experience, and risk management, Day-Trading can be very challenging at the very least. Data seems to confirm that 97% of day-traders lose money, and many suffer a significant hit to their portfolio, which often results in demoralization, and the ultimate destruction of their confidence. Day-trading, which is defined as opening and closing trades in the same session (also referred to as intra-day) moves very fast and can be highly intimidating.
With the correct approach, however, it doesn’t have to be that way. For the average new and intermediate investor, all the reasons listed above are important for potential success. Risk Management, however, may be the most pertinent to ensure control over one’s account, even when trades are not successful.
The 3-5-7 Rule is one such strategy designed to balance the risk-to-reward ratio for active traders, to protect from major losses. Following the simple guidelines of this rule will not only avoid large losses, it also maximizes the potential for gains. Following are the key factors to this rule…
RISK – Allow only 3% risk on any trade. This essentially requires a 3% stop-loss on each and every trade to ensure you “stay in the game,” especially during losing stretches. Remember, as we often stress, do not place these orders in the system, to avoid manipulation by market-makers, as they can be seen on public platforms. Documenting on paper, or keeping them mentally, is best, so long as the rules are strictly followed. It is also suggested to keep ALL open day-trading positions at 5%, or less, of your portfolio, for the same reasons. During any winning trades that continue to increase profit, one should also consider a “trailing-stop” (also discussed in our publication), to secure a designated level of profit. For instance, for those who wish to start with small accounts, say $10,000, the maximum risk on one day-trade should be $300 (3%). If you already have an open day-trade risking $300, the second trade should only risk $200, as $500 equals 5% of the account.
PROFIT – Target a minimum 7%, as a profit-to-loss ratio. This strategy helps improve profitability, and protects against a lower win rate. As that rate increases it will result in higher average gains. Remember that you are risking 3%, so it essentially makes no sense to set your profits at the same, unless your win rate is extremely high. Using the same account example as above, the target profit would be set at 7%, which equals $700. Using the 3% risk figure, if one were to win only 1 of 3 trades over any time frame, they would still be profitable. The 1 winner that produced a 7% win ($700) would surpass the 2 losers that produced 3% losses ($600), for a $100 net profit. That win rate is only 33%, indicting the higher the rate, the more profitable one would be. That would also leave a “window” on the winning trade of $100, to set a trailing-stop if one wishes to keep that trade open for more potential profit, and still enjoy a net gain.
POSITION – Keep the number of shares or funds (position size) low, and consistent, until you become more experienced. Emotions are harder to control the larger the risk, and the point is to become a consistently successful trader, not an overnight millionaire. Start with a low amount, document your trades, learn from your mistakes, improve your win rate, and become proficient before raising the stakes.
ADJUSTMENT – Once you have gained some experience and comfortability trading, correlate position size to market conditions. During calmer, less volatile periods in the market, or with stocks with lower daily Average True Ranges (ATR), you may wish to raise the position size, while lowering it during higher volatility times, or with wider range equities. The “speed” of the market also plays tricks on the mind, and this adjustment can be very beneficial to reduce over-reaction to increased price action.
As always, set a plan and stick to it! Pre-determine your risk, set your parameters, follow the system and not the money, and keep emotions under control, and your trading activity can be beneficial.
*** As always, this information is not intended to be financial advice, and should not be considered as any specific buy or sell recommendation, but rather a guide to assist the reader in some further understanding of the financial markets.
