As with any trading strategy, risk management and discipline are key ingredients for success.

Basic risk management includes 1) proper position sizing, 2) use of stop loss orders, and 3) risk-reward-ratio.

Proper position sizing. 

Typically, a trader should not risk more than 2% of his entire portfolio. That does not mean his positions should be 2% of his portfolio.  There’s an important difference.

If a trader determines that a new trade has a 20% max downside, his portfolio is $100K (equity not using leverage or margin), and wants to use 2% max loss rule then his position size should be $10K.

Because if he loses 20% of $10K, that’s $2K, which represents 2% of his entire portfolio’s equity ($100K). Expressed in a formula: Position = (Max Loss (i.e. 2%) * Portfolio Equity (i.e. $100K)) / Max Downside (i.e. 20%).

Stop Loss orders. 

Traders should place a Stop Loss at such price level so as to allow for normal movement within a trend, giving it room to breathe and bounce back, yet not too far. One common technique is to set a Stop Loss to below the low of the most recent trough for an uptrend. In the case of COMP (Compound) in the below chart, the most recent trough was around $550.

Target an RRR. 

Using the aforementioned Stop Loss strategy, if a trader were to Buy COMP on a pullback around $600, the downside would be $550 ($50 or 9%) and his upside would be $700+ ($100+ or 17%+) for a decent risk-reward-ratio (RRR) of 1:2 or better (50 / 100+).  Many traders target a 1:3 ratio.

Here’s also a helpful RRR for risk management using RRR.