A new generation of traders is grappling with recent market volatility and learning some difficult lessons along the way — hard-fought lessons that all traders confront. A veteran trader offers Yahoo Finance viewers some key insights and a quick review of some time-tested risk management techniques.
Stephen "Sarge" Guilfoyle, president of Sarge986 LLC, hammers home the importance of setting up each trade in advance with predefined prices to buy and sell. "You want your winners and your losers to be in your head before anything happens because then there's no emotion involved," he said.
A trade's potential exit areas are just as important as the entries — and all of them combine to create a potential map of the trade (whether it wins or loses). In general, many active traders look for a potential reward that's three times the initial risk of potential loss. To achieve this reward-to-risk ratio of 3-to-1, Sarge recommends setting a target at least 20%-25% above the entry level. To protect against losses, a stop (or "panic level," as he calls it) should be about 7% to 8% below the entry.
"This way, even if you're right half the time, you're going to make money because your targets are three times higher than your panics," said Sarge. "You're going to lose money sometimes. You'll get shaken out. But you'll never take more than an 8% hit unless it happens while you were asleep."
A trader faces daily challenges and unknowns, so it's all the more important to manage the known risks and to have a plan to deal with outlier events. News can make the stock volatile, illiquid and subject to trading halts. And as we've seen many times over the past year — even trading apps can fail. Thinking ahead can save precious time in the heat of the moment.
To illustrate these techniques, Sarge breaks down a long view of Warren Buffett's Berkshire Hathaway stock (BRK-B).
"I like Berkshire," said Sarge, who explains the classic pattern shown above. "I saw the big cup with handle form— right up until about August is when you saw the handle start. And the handle runs through November. In late November, we see the breakout. The breakout kind of fails, but it comes back. But we see support right at the pivot point in December and it's still trying to breakout."
He then outlined the key levels he's watching. "My target price for Berkshire B is $283. The pivot was $233. You can see it on the chart. And now my panic point on this stock is $218. Because every good trader has a target and a panic. You don't trade without either one of those."
With a "panic," or trading stop, at $218 and a target of $283, an average entry around the $233 pivot would yield a potential profit of $50 with a $15 stop — yielding a reward-to-risk ratio of 3-to-1.
Sarge reminds us that at the end of the day we're here for one reason, and managing entries and exits is key. "The whole idea here is to make money. If you do it — whether the stock goes up or you bring your net basis down — either way, you're a winner," he said.
Jared Blikre is a correspondent focused on the markets or Yahoo Finance Live. Follow him @SPYJared