Expert Level

Learn advanced topics about trading strategies, risk management and more.

Lesson 11: Risk Management Techniques

Risk
management helps to reduce risks. It can also help protect the account of a
trader from losing all of his or her money. There is a threat when the trader
takes a loss. If it can be handled, the trader can open it up to make money on
the market.

It is an
important, but often ignored, prerequisite for effective active trading. After
all, a trader who has generated significant profits could lose all of this in
only one or two bad transactions without a proper risk management plan. So how
do you develop the best techniques to reduce business risks?

This
article discusses several basic techniques that can be used to secure your
trading profits.

Planning Your Trades

As Chinese
military general Sun Tzu famously said, “The battle is won before it is fought.”
This phrase implies that planning and strategy—not battles—win wars. Similarly,
effective traders often quote the expression, “Plan trade and sell the plan.”
Just as in war, planning ahead can often mean the difference between success
and failure.

Next, make
sure your broker is right for regular trading. Many brokers appeal to clients
who seldom deal. They charge high commissions and do not provide the right
analytical tools for active traders.

Stop-loss
(S/L) and take-profit (T/P) points are two key ways traders can plan ahead
while trading. Successful traders know what price they’re willing to pay, and
what price they’re willing to sell. We can then calculate the resulting returns
against the likelihood that the stock will meet their targets. If the modified
return is high enough, the trade is carried out.

Conversely,
ineffective traders often engage in trade without having any idea of where they
will sell at a profit or a loss. Like gamblers on a lucky, or an unlucky,
streak, emotions begin to take over and determine their trades. Losses often
encourage people to hold on and hope to make their money back, while losses can
cause traders to hold on unwisely for even more gain.

Remember the One-Percent Rule

Most day
traders obey what is called the one-percent rule. Essentially, this rule of
thumb implies that you should never put more than 1% of your money or your
trading account in a single transaction. So, if you have $10,000 in your
trading account, your investment into any asset should not be more than $100.

This
tactic is popular for traders who have accounts of less than $100,000, some
even go as high as 2% if they can afford it. Many traders whose accounts have
higher balances may choose to have a lower percentage. That’s because the size
of your balance increases, so does the place. The best way to keep your losses
in check is to keep the rule below 2%, any higher, and you could lose a
substantial amount of your trading account.

Setting Stop-Loss and Take-Profit
Points

A
stop-loss point is the price at which a seller sells a stock or makes a trading
loss. This often happens when a deal does not turn out the way the trader
wished for. Points are designed to prevent a “coming back” mindset
and reduce losses until they escalate. For example, if the stock falls below
the key support point, traders always sell it as soon as possible.

On the
other hand, the take-up point is the value at which the dealer can sell the
stock and make a profit on the deal. This is when, given the risks, the
potential upside is minimal. For example, if the stock is approaching the main
resistance level after a big upward push, traders may want to sell before the
consolidation phase takes place.

How to More Effectively Set
Stop-Loss Points

Setting
Stop-Loss and Take-Profit Points is often achieved using technical analysis,
but fundamental analysis can also play a key role in timing. For example, if a
trader is keeping a stock ahead of earnings as an anticipation grows, he or she
may want to sell it before news hits the market if expectations have become too
high, regardless of whether the take-up price has been reached.

Moving
averages are the most common way to set these thresholds, as they are easy to
calculate and commonly followed by the market. The moving averages are 5-, 9-,
20-, 50-, 100-, and 200-day averages. These are best measured by adding them to
the stock chart and by evaluating whether the stock price has responded to them
in the past as either a support or a resistance point.

Another
good way to put a stop-loss or take-profit rate is through aid or resistance
patterns. These can be derived by linking previous highs or lows that occurred
at a large, above-average size. As with moving averages, the aim is to assess
the rate at which the price responds to the movements and, of course, to the
high volume.

Here are
some primary considerations when setting these points:

  • Use
    longer-term moving averages for more volatile stocks to reduce the chance that
    a trivial price change would cause a stop-loss order to be executed.
  • Change
    the moving averages to match the target price range. For example, longer
    targets should use lower moving averages to reduce the number of signals
    produced.
  • Stop
    losses should not be more than 1.5 times the current high-to-low range
    (volatility) as it is too likely to be performed without justification.
  • Change
    the stop loss based on market fluctuations. If the stock price doesn’t drop too
    much, the stop-loss points can be tightened.
  • Using
    known key events, such as the release of earnings, as key timeframes in or out
    of trade, as volatility and uncertainty may increase.

Calculation of the Expected Return

Setting of
the stop-loss and take-profit points is also important to measure the expected
return. The value of this measure cannot be overstated, as it allows traders to
think through and rationalize their trades. It also offers them a structured
way of comparing different trades and choosing only the most profitable ones.

This can
be determined using the following formula:

[ (Probability of Gain) x (Take Profit
% Gain)] + [ (Probability of Loss) x (Stop-Loss % Loss)]

The
outcome of this equation is the expected return of the effective investor, who
will then evaluate it against other incentives to decide the stocks to sell.
The likelihood of gain or loss can be estimated by using historical breakouts
and aid or resistance rate breakdowns — or by making an educated guess for
experienced traders.

Diversify and Hedge

Make sure
you make the most of your business means not placing your eggs in a basket.
When you put all your money in one stock or one instrument, you’re going to
make a big loss. So, note to diversify your investments, through trade, market
capitalization, and geographic regions. Not only does this help you control
your threat, it also opens up more doors for you.

You may
also find yourself at a time when you need to defend your spot. Find the stock
position where the results are expected. You can consider taking the opposite
position by options that can help protect your position. If trading activity
goes down, you can unwind the hedge.

The Bottom Line

Traders should always know
if they plan to enter and leave a trade before they do so. When successfully
using stop losses, a trader can reduce not only profits, but also the number of
times a transaction has become unnecessary. In summary, make your battle plan
ahead of time, so you’ll know you won the fight.