- Understanding risk management and risk mitigation
- Identifying reasons behind incurring losses
- Developing techniques to plan and mitigate risks
- Notes to controlling risk and enhance success in trading
A penny saved is a penny earned, is the mantra you need to adopt if you want to succeed in stock trading. Therefore, the risk mitigation strategies you adopt are as crucial as your stock trading strategies. You need to plan for every disaster and have specific risk mitigation techniques to lessen its impact.
Risk mitigation is an element of risk management. Different traders adopt different types of mitigation techniques. The same trader may also use various techniques under different circumstances to keep risks at bay.
Why do losses occur?
This is an important question that needs addressing. Once you understand the reasons behind incurring losses, it gives a clearer picture of how to be aware of them and take corrective action against problems.
Here are some of the common reasons for failure in stock trading:
Lack of discipline: Many people give discipline the least significance, which becomes their biggest undoing. An occasional winning trade without observing trading discipline may instil false confidence in you, which may eventually result in disasters. To be successful in stock trading, you need to crush your ego, have faith and develop confidence in your trading skills.
Relying on rumours: While most broking houses provide daily trading ideas to their clients, many traders still rely on rumours and “tips.” Since stock trading is still not considered an independent profession, very few rely on analysis and diligent studying.
Rush to make a quick buck: Often, people consider stock trading as a fast way to make a lot of money. Also, when they incur losses, they try to average out or enhance exposure to recover the loss without realising the fact that by doing so, they are just adding to their mistakes.
Tendency to panic: When things do not move according to one’s expectations, one either panics or becomes restless and gives up, thus incurring losses. In fact, when one panics, they’re only enhancing the chances of failure. Patience and a cool head are the hallmarks of a successful trader.
Loss Aversion: Behavioral finance, which has gained a lot of prominence in recent years, has shown that humans tend to avoid losses. When a trade is going against us, we may want to avoid booking the loss since it is tough for our minds to accept the loss. When the position is still open, there is still a hope factor which is playing at the back of the mind. But it is this hope which is the worst enemy of a trader.
A small loss can turn into a big loss, and then finally, the trader may accept it or see the bought option go towards zero. In investing, some people are of the opinion that till it is not realised (or booked), it is not a loss. But in trading, this concept is dangerous and can hurt you.
How to minimise losses
Regular analysis of your actions, which might have resulted in profits or losses, will give you valuable lessons for your future dealings. It will also throw light on the various do’s and don’ts in the market. A well-planned risk mitigation strategy should be able to identify the possible risks and assess and monitor them. In fact, risk mitigation should be considered as part of the trading strategy.
Risk mitigations steps that will help you go a long way include:
Risk acceptance: This is a strategy usually followed by a trader when the potential loss from risk is not huge. A trader may go for such trades when he expects potential gains far outweigh potential losses.
For example, on F&O expiry days, when the options premium on Nifty starts moving towards zero, some traders often take small positions in puts or calls if they expect sudden downside/upside movement in the Nifty. They take risks as the potential loss is small, while the potential profit from a sudden fall or spurt is huge. Here too, risk assessment is required, which is straightforward in this case.
Risk avoidance: Risk avoidance means keeping away from events that are likely to bring in negative returns. Such steps are taken when negatives outweigh positives or when the potential loss could be huge to bear. Risk mitigation usually aims at reducing the probability or the negative impact of the risk, while this aims at complete elimination (of risk) by avoiding the trade itself.
For example, many traders avoid option writing as it involves unlimited risk of loss while the maximum gain is limited and fixed.
Risk reduction: A risk reduction strategy accepts the existence of risk but aims to reduce its impact through specific measures. Unlike risk avoidance, this strategy reduces the risk of loss but at the same time keeps alive the channel to make profits. It involves taking countermeasures to decrease the impact of consequences.
Usually, stock traders reduce their risk of loss by placing stop-loss orders. This authorises the broker to sell (or buy in case of short sales) stocks automatically when their price goes down (or up) to a specified level, which protects traders from excessive loss.
Risk control: This aims at minimising the impact or likelihood of risks. This method may involve some cost that may have to be incurred even if the potential risk doesn’t materialise. Traders usually try to reduce their risks by hedging their positions.
A stock trader can hedge the risk in one trade by taking an offsetting position in another. Hedging techniques such as strangle, straddle, and iron condor are adopted as popular strategies in stock trading.
Points to remember:
- There is no success without organised planning
- Before you enter the arena, plan your trade and execute it in the market accordingly
- Properly planned risk mitigation strategies enhance opportunities and reduce threats
- Make risk mitigation planning, implementation and monitoring part of your trading strategy