Last week was one of the craziest periods in the market in the last couple of years.

Going into the week, the major indexes were positive, bouncing off their recent short-term lows. They gapped higher and rallied into the middle of the week.

That sharp rebound marked a 4.4% and 3.3% turnaround in the Nasdaq and S&P 500, respectively. Those are big moves in the space of just a few days.

But just as the bulls were cheering, the market turned around and bit them… hard.

By Friday, those indexes had given up their gains. Worse still, they closed out the week below the low before the up move.

Many investors get smoked during moves like this. But that’s why I’ve always traded the markets differently…

Risk Management Comes First

A lot of folks focus on profits first. Risk management comes a distant second.

Of course, there’s nothing wrong with making a profit. That’s the reason we trade in the first place.

But by my way of thinking, this puts things out of order. Risk management needs to be front and center in your strategy.

I blew up my trading account multiple times before I grasped this. Only when this lesson clicked was I able to make it as a full-time trader. I went on to run my own multimillion hedge fund, which Barron’s ranked in the top 1% multiple times.

But when folks talk about risk management, they’re not always thinking about the whole picture…

Sure, we all want to make a lot of winning trades. But the goal of any trader is to protect their capital.

That means only taking trades with strong setups. Then you exit that trade if the thesis no longer holds up. You can use a predefined exit point, such as a stop loss. That way, the decision is already made before emotions overwhelm your judgment.

Plus, you should only risk a small portion of your money on any one trade. And never trade with money you can’t afford to lose. You’ve probably heard these lines so many times that they bounce off your ears.

So take a moment to consider what that means for you.

If you’re risking 10% or more of your trading funds on a single trade, are you comfortable taking on that kind of risk?

There’s a reason I recommend choosing a number like 2% or 3% of your funds for each trade. It means you’d have to have a serious losing streak before you’d really start worrying about blowing up your account.

And certainly, if you’re risking money you need for living expenses or that would put you at risk of hardship, I’d encourage you to reconsider.

There’s something that these old tried-and-tested rules don’t cover that is important as well. And it applies now as much as ever…

The Right Strategy Is Key

Your first job is to protect your capital. But you can’t do that unless you’re using the right strategy for the market conditions.

As last week showed, even the best stock-buying strategy will hurt when the market reverses and heads south. Just one more leg down will put us on the cusp of bear market territory. When stocks are falling, “buy and hold” strategies will have you tearing your hair out.

That’s when options begin to make so much sense. It’s why they’ve been a cornerstone of my strategy for 40-plus years.

By using options, I always know the maximum amount I stand to lose if the trade doesn’t go my way. Many stock investors could not say that last week unless they had stop losses across all their positions.

With options, I can adjust my strike price to match the maximum risk I want to take. For example, if I only want to risk $300 or $400 per contract on a trade, I can find an option that will suit my criteria. That greatly enhances my ability to manage risk.

Another benefit of options is their flexibility. With options, I can shift from profiting from up moves (being “long”) to profiting from down moves (being “short”) in just a few minutes. I’m not wedded to any direction and can quickly pivot as the situation dictates.

I can also be long and short at the same time if I have opposing views of different stocks or sectors.

So, when markets are bouncing around like they are now, think carefully about risk management.

Then, make sure you’re using the right strategy for the market conditions.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict