Risk management is a crucial aspect of trading as it helps reduce losses and safeguards a trader’s account from complete depletion. When traders effectively manage risk, they create opportunities for profitability in the market. It is an often overlooked but essential prerequisite for successful active trading, as even traders who have generated significant profits can lose everything with just a couple of unfavorable trades if they lack a proper risk management strategy. So, how can you develop effective techniques to mitigate market risks? This article will discuss simple strategies that can protect your trading profits.
Trading can be both exciting and profitable if you can maintain focus, conduct thorough research, and keep emotions in check. However, even the most skilled traders need to incorporate risk management practices to prevent losses from spiraling out of control. Employing a strategic and objective approach to cutting losses through the use of stop orders, profit-taking, and protective puts is a smart way to stay in the game.
Planning Your Trades #
Planning your trades is akin to the wisdom of Chinese military general Sun Tzu, who famously said, “Every battle is won before it is fought.” This implies that planning and strategy, rather than the battles themselves, determine victory or defeat. Successful traders often quote the phrase, “Plan the trade and trade the plan.” Planning ahead can make a significant difference in trading outcomes.
To begin, ensure that your broker is suitable for frequent trading. Some brokers cater to infrequent traders, charging high commissions and lacking the necessary analytical tools for active trading. Stop-loss (S/L) and take-profit (T/P) points are essential for planning ahead when trading. Successful traders determine the price they are willing to pay for a stock and the price at which they will sell. They then assess the potential returns against the probability of reaching their goals. If the adjusted return meets their criteria, they execute the trade.
Conversely, unsuccessful traders often enter trades without any predetermined selling points for profit or loss. Emotions start to take over, akin to gamblers on a lucky or unlucky streak. Losses may lead traders to hold on, hoping to recover their money, while profits can tempt them to hold on imprudently for further gains.
Consider the One-Percent Rule #
Consider adhering to the one-percent rule, a common practice among day traders. This rule suggests that you should never allocate more than 1% of your capital or trading account to a single trade. For example, if your trading account holds $10,000, your position in any instrument should not exceed $100. Traders with accounts below $100,000 may even go up to 2% if feasible. As the account balance increases, the percentage is typically reduced to avoid risking a substantial portion of the trading account.
Setting Stop-Loss and Take-Profit Points #
Setting stop-loss and take-profit points is vital in risk management. A stop-loss point represents the price at which a trader sells a stock to limit losses when a trade doesn’t go as expected. It aims to prevent the “it will come back” mentality and mitigate losses before they escalate. On the other hand, a take-profit point is the price at which a trader sells a stock to secure a profit when the upside potential is limited. Traders may sell if a stock breaks below a key support level or approaches a significant resistance level after a substantial upward move.
How to More Effectively Set Stop-Loss Points #
When setting these points, technical analysis is commonly employed, but fundamental analysis can also play a role. For instance, if traders anticipate high market expectations ahead of earnings, they may sell before the news is released, even if the take-profit price has not been reached. Moving averages and support or resistance trend lines are effective tools for determining these points.
To set stop-loss and take-profit levels effectively, consider the following:
- Use longer-term moving averages for volatile stocks to minimize the risk of premature stop-loss executions.
- Adjust the moving averages according to the target price ranges. Larger moving averages are suitable for longer targets to reduce the number of generated signals.
- Set stop-loss distances at least 1.5 times the current high-to-low range to avoid unnecessary executions.
- Adapt the stop loss to market volatility. When the stock price is less volatile, tighter stop-loss points can be used.
- Take advantage of known fundamental events like earnings releases to make informed decisions about staying in or exiting a trade due to increased volatility and uncertainty.
Calculating Expected Return #
Calculating the expected return is crucial in risk management as it prompts traders to think through their trades and select the most profitable opportunities. The expected return can be calculated using the following formula:
(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)
Traders can then compare the expected returns of various trades to make informed decisions.
Diversify and Hedge #
Diversification is key to maximizing trading outcomes and managing risk. Avoid putting all your capital into a single stock or instrument to prevent significant losses. Diversify across industry sectors, market capitalization, and geographic regions to broaden your opportunities and reduce risk.
Hedging can also be useful in certain situations. For example, consider hedging a stock position when the results are due. You can take the opposite position through options to protect your position. Once trading activity subsides, you can unwind the hedge.
Downside Put Options #
Furthermore, if you have options trading approval, purchasing downside put options (protective puts) can act as a hedge to limit losses in a deteriorating trade. A put option grants the right, but not the obligation, to sell the underlying stock at a specified price before the option expires. By owning a put option, you establish a floor for potential losses.
The Bottom Line #
In conclusion, traders should always determine their entry and exit points before executing a trade. Effective use of stop-loss orders can minimize losses and unnecessary trade exits. Remember to plan your trades ahead of time, just as strategists plan battles before engaging in warfare. By incorporating risk management strategies, you increase your chances of success in the trading war.