Risk Management — Stops, Hedges, and Drawdowns

The Math of Coming Back

Drawdowns get harder to recover from quickly:

A 50% loss needs a 100% gain just to break even. This is why pros obsess over downside protection. Big losses don't just hurt — they break compounding.

Stop-Losses — The Simplest Risk Tool

A pre-set exit price. If the trade goes there, you sell — no thinking, no hoping, no "but it's coming back."

Where to Place Stops

• Below recent support — if support breaks, your trade thesis was wrong
• Below a key moving average — 50-day or 200-day, depending on timeframe
• A fixed percentage — 7-10% for swing trades, 15-20% for long-term holds
• Volatility-based — wider stops in volatile stocks, tighter in calm ones

When NOT to Use Stops

• Long-term, high-conviction holds — temporary 30% drawdowns are normal in great stocks
• Right at obvious round-number levels — algorithms often "hunt" stops there

For Buffett-style investing, the stop is your fundamental thesis. If the business deteriorates, you exit — not because of price.

Trailing Stops — Letting Winners Run

A trailing stop moves up as the stock rises, but never down. Example:

• Buy at $100
• Set 15% trailing stop → stop at $85
• Stock rises to $120 → stop trails to $102 (15% below new high)
• Stock falls to $102 → you exit, locking in $2 profit

It's the closest thing to "have your cake and eat it too" in markets — you cap downside while staying in for the upside.

Risk-Reward Ratio

Before any trade, ask: "How much can I make vs. how much can I lose?"

• Entry: $100
• Stop: $95 (-5%)
• Target: $115 (+15%)
• Risk/Reward = 3:1

A 3:1 setup that wins only 40% of the time is profitable:

(0.4 × $15) - (0.6 × $5) = $6 - $3 = +$3 per trade

You don't need to be right often. You just need to be right when it matters.

Hedging

When markets get scary, you don't always have to sell. You can buy protection:

• Put options — pay a premium, profit if the stock falls
• Inverse ETFs — go up when the index goes down
• Cash — the simplest hedge of all
• Short positions — profit from declines (advanced and risky)

Hedges cost money in normal markets. Treat them like insurance — you don't expect to "win" on them; you want them to be there when the storm hits.

The Drawdown You Can Live With

Before any market turmoil, ask yourself honestly: "How big a drawdown will I sit through without panic-selling?"

• 10%? Most people can.
• 30%? Many bail.
• 50%? Only the most disciplined hold.

That answer determines your stock/bond mix more than any optimization model. A portfolio you'll hold through pain is better than a "perfect" one you'll panic-sell at the bottom.

The Three Rules

1. Never risk more than you can afford to lose.
2. Cut losses small. Let winners run.
3. Live to invest another day.

The best traders aren't the ones who win the most — they're the ones who lose the least when they're wrong. That's the whole edge.