Skill Sheet: What You Will Learn Here
- What are the common risks in trading?
- Easy ways to minimise trading-related risks
Risk management in stock trading is a tightrope walk as wild price movements can go against a trade resulting in the risk of losses. Risk management is paramount for a trader; when ignored, a trader can blow his account. It is a process that is employed to keep losses in check. Considering risk is important even before a trade is initiated, as the return is a multiple of risk. Markets have wild swings and can be erratic; therefore, the risk is inevitable. The risk manifests when the underlying moves against the expectation. Risk management is employed to guard against such moves to minimize losses.
What is risk in trading?
Risk in trading can be defined as the possibility of losing the money invested. A risk becomes even more magnified if an investment or exposure is leveraged. A leveraged account is a double-edged sword. It can not only give a better return on investment but also can multiply losses. Therefore, the greater the leverage, the greater the risk. A trader is exposed to a larger share of profits or losses by paying a small margin. If a trader wishes to trade in the Nifty 50 index, he has to pay an upfront margin of Rs.1.10 lakh for a lot size of 50 shares of nifty. If nifty goes up, he will make a profit on the entire Rs.1.1 lakh exposure, but he will also make losses on it. While making profits on every trade is impossible, it is important to minimise the losses. This is where risk management comes in handy.
How can you manage risk?
There are some important rules or requisites for managing risks. This begins even before a trade is taken. Planning a trade, understanding risk-reward, position trading, percentage method and setting stop losses.
Let’s look at each of these rules in a little more detail.
Planning a trade is the most important step, as there is clarity in your mind regarding what needs to be done in various situations. A plan includes a decision on the capital you want to employ, the timing when you want to enter or exit a trade and how much risk you are ready to take.
Fixing a risk-reward ratio – The risk-reward ratio outlines the risk you are ready to take against the reward you expect. Understanding the risk-reward upfront ensures market entries and exits are planned well. Traders generally employ a risk-reward ratio of 1:2 or 1:3, depending upon their risk appetite. Fixing a risk reward will help you avoid overtrading.
Position sizing – This is another key ingredient in risk management. Position sizing means the right amount a trader will use to open a trade. Random position sizing and succumbing to emotion and gut feeling can prove fatal. Apart from preventing excessive losses, position sizing helps in maximising profit. A small capital will never give you huge returns; therefore, finding the right balance is important.
Position sizing can be done using a fixed value method or percentage method.
The fixed value method involves taking a trade with a fixed value. For instance, if the available capital is Rs 10 lakh, you can allocate a maximum value of Rs 1 lakh per trade. This implies that you can take ten different trades instead of putting the entire Rs 10 lakh in one trade. The risk per trade thereby is restricted, and even if the first few trades go wrong, you still have enough capital to bounce back.
The percentage method uses a fixed percentage per trade to limit the risk. A 2-4% risk can be a good percentage to begin with. Since it is a percent calculated on the capital, the risk capacity increases as profits are added to the capital. So, for instance, a 2-4% risk on a capital of Rs 1 lakh amounts to Rs 2,000- 4,000. Now suppose a profit of Rs 10,000 is added to the capital of Rs 1 lakh, the total capital increases to Rs.1.1 lakh and the new risk will now be Rs 2,200 - 4,400.
Setting stop losses – This will limit the losses of an existing position. Suppose a trader has bought Nifty futures at 17,700 and limits his loss by a stop loss order at 17,600. The moment Nifty falls below 17,600, the trade is exited automatically. Similarly, trailing stop losses are used to lock in profits. Traders generally use support and resistance, average cross-overs, retracements etc., for exiting trades. Scalpers use the number of points gained or lost to exit trades, both profits and losses.
Protecting your capital is very important if you want to trade for another day. Trading is risky, and leveraged trading is double the risk. Therefore, it is always good to plan a trade considering the abovementioned points. Happy and safe trading!