Risk Management when Stock Trading

All businesses have inherent risks attached.

A shop owner may have to consider the risk of produce being left unsold on the shelf, the possibility that key staff leave for pastures new, electricity supply gets disrupted, or tax laws change. Or a whole host of other possible risks to his business.

To alleviate such risks he may cut prices, initiating sales periods, or hold key persons insurance or have a staff lending and borrowing policy with a nearby store in the same chain. He might have a back-up generator, and will most definitely employ an accountant.

In other words, he manages his risk on a daily and ongoing basis. He identifies areas of risk, assesses impact, and then prioritizes necessary remedial action.

As a stock trader, you’ll need to do the same. By managing the risk associated with your portfolio, you’ll increase your chances of increasing profits, and decrease your chances of being hit hard by the unexpected. There are several areas in which you need to identify and assess your risk, and several things you can do manage that risk successfully.

Position Size

Unless you’re Warren Buffet, you will have a finite fund to commit to the markets. You’ll need to consider the size of this fund, the anticipated (or required) profit, and the potential loss. It’s no good committing all of your funds, if to do so would jeopardize future trading.

Many active traders set a limit on the maximum risk they will take per trade. For example, you may decide that you will only take a risk of 2% of your funds on any single trade. If you have $100,000 in your trading account, and your stop loss (see below) is set at 5%, then this means that the maximum trade size you will employ is (($100,000×2%)/ 5) x 100 = $40,000. If your stop loss is triggered, you will lose $2,000.

Using this sort of risk management strategy means that you would have to have 50 losing trades in a row to see your account fall to zero. Position size management should go hand in hand with a disciplined stop loss philosophy.

Stop Loss Orders

Knowing your maximum downside, the most you are prepared to lose on a trade, is one of the main rules of risk management when trading stocks. Utilizing a stop loss order on each position you open will mean that your trading system and strategy removes the emotional tie to a trade, and helps to keep your trading disciplined. Losses will occur: capping those losses is a key to profitability.

When your position moves into being profitable, then you can use a stop loss to prevent profits evaporating. Many traders use a trailing stop to take advantage of increasing profits whilst limiting the downside at increasing prices.

Diversification and Hedging

My grandmother once told me I should never have all my eggs in one basket. It was until I started stock trading that I really understood what she meant.

It’s easier to lose money if all your funds are in a single stock, than if you have spread across several. Some win, some lose. It’s the way of the market. Even if you are trading in only one sector, then you should consider spreading your funds across several stocks.

Becoming good in different market sectors is even better: when one sector is cold, another will be hot. Diversifying isn’t just about spreading risk, it’s about creating opportunity.

Similarly, there are times when you will need to hedge your position. You may have a stock position with the results due. Taking an opposite position by way of options, for example, will mean that your position is protected over the time of the results. You can then unwind the hedge when trading has calmed down.

Some traders hedge their day trading book by taking a long position in one stock, and a short position in another ‘look=alike’ stock, hoping to profit on both.

Pick Your Spots

This will be part of your trading strategy. Pick the prices at which you are happy to buy and sell your stock. Use limit orders and other order types to maximize these opportunities.

You might use technical analysis and charts to provide directional decisions, or you might trade with a longer term view and employ fundamental analysis methodology. Whatever you choose, knowing your buying and selling levels will mean you trade with more conviction and with greater relaxation and discipline.

Your trading levels will also impact upon your stop loss orders, and your profit taking and exit strategy.

Cut your losses, Run Your Profits

Some traders have a target and take profits when that target is met. Others allow profitable positions to run, perhaps utilizing trailing stops to help maximize profits.

A good profitable trader will cut losses, maybe by using stop loss orders as described above.

It stands to reason that if you are disciplined, sticking to maximum loss levels and picking your spots for buying and selling, and then reacting accordingly, by cutting losses and running profits your trading results will benefit.

A gain isn’t a gain until it has been realized

Remember that at some time you need to take your profits. It’s not money until it’s in your bank account. This means that you need to be aware of what profit you want to take from your trade. Too many traders see a position move to their target price, and then decide to hang on for a few more pennies: after all the stock is hot.

When the stock moves down a little, they continue to hang on: it’s just a temporary downside in an upward trend. Then the unthinkable happens. The stock falls through the price at which they bought the stock.

Don’t get caught in this trap. Risk management doesn’t stop at knowing when to take a loss or how to minimize losses: it’s also about knowing when to take profits.

The Bottom Line

Good trading isn’t about always picking the right stocks, or the right prices. It’s as much about managing your risk, and integrating a strong risk management philosophy into your trading strategy. A senior market maker once told me that a trader isn’t a trader until he’s lost $10,000 on a single transaction. Employing good risk management will mean this never happens to you.

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