Risk Management in Trading
A very important and often neglected step for the success of any active trade is the management of risk. The hard earned profits of the trader could at the end of the day be lost due to the mismanagement of risks in the trade.
Risk management plays an important role in the life of an active trader. After all, a trader can make 90% winning trades, but if the 10% of losing trades are mishandled, they can lose money on a net basis.
Proper planning of trade
A very important saying by the Chinese military general Sun Tzu’s goes like this, “Every battle is won before it is fought.” It means that it is the plans and the strategies that win and not the battles. In a similar manner successful traders quote it this way, “Plan the trade and trade the plan”. Planning the trading strategies right at the start could differentiate between success and failure.
Stop-loss (S/L) and take profit (T/P) are the points representing the two key ways which enables a trader to plan at the very start of the trade. Traders who are successful know what prices to pay and what prices to sell at. They do measure the returns obtained against the probability of the stock hitting their goals. If the return so adjusted has a permissible value, that is it is high enough, then trade gets executed.
Stop-Loss and Take-Profit Points
The price at which the trader will sell a stock and take up a loss on the trade is denoted by the stop-loss point. This might happen when sometimes the trade deviates from the path that would have led to a profit. It is used to limit the losses before they go out of hands and render a “it will come back” mentality.
Conversely, the price at which the trader will sell a stock and will take up a profit on the trade is denoted by the take-profit point.
Cutting Losses
“A stop-loss is a pre-planned exit order for a losing trade.” A broker platform is the place where it can be executed manually or automatically. Cutting losses before they expand abnormally is the main aim. To stop out of a lost trade is probably the most difficult thing for day traders. Failure to stop could lead to margin calls, unwanted huge losses leading to account blowouts.
Effectively setting up Stop-Loss Points
Technical analysis often plays role while setting stop-loss and take-profit points although fundamental analysis could also be used.
Moving averages are the most used way to set these points. 5-, 9-, 20-, 50-, 100- and 200- day averages are the key moving averages. It is considered to be the best set when applied to the stock’s chart and in determining whether the stock price reacted to them in the past either as the support or resistance level.
Yet another way to place stop-loss or take-profit is on support or resistance trendlines.
Calculating Expected Return
Calculating expected return makes setting stop-loss and take-profit points a necessity. It forces traders to think through their trade and rationalize them. It also gives them a scope to judge different trades, make a comparison and select the most profitable ones.
Risk/Reward Ratios
Day traders who are successful are normally aware of both the potential risk and reward even before entering the trade. The goal is to place trade only at the point where the “potential reward outweighs the potential risk”. A risk/reward ratio is nothing but the amount the trader plans to risk as compared to the money which the trader thinks he would gain.
Frequency
Traders who meet with success are disciplined enough to select only those trades that fulfill the criteria as per their plans and offer high probability of profits. A new trader should take up limited number of trades that would enable them to take the right opportunities.
Duration
This refers to the amount of time spent in a particular position. It is always wise to trade on smaller time frames as it reduces the risk faced in trade.
Volume
Volume is another important aspect referring to share size which should be carefully handled to minimize risks.
