By: Ganesh Adhikari
Risk management means minimizing loss. Risk management strategies are essential to becoming a successful trader. Without risk management, one bad trade can take away all the profits generated. Thus risk management skill is vital to avoid huge losses.
One of his most famous sayings in the stock market is “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1”. Even the most successful investor Warren Buffett abides by this rule and also suggests others to do the same.
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Risk Management Strategies
1. Plan before trading
“Every battle is won or lost before it is ever fought” – Sun Tzu (Chinese military general) – The Art of War.
Before entering into any trade one must have a clear plan about the entry and exit positions, when to hold, and when to let go of the shares. A simple and successful risk management strategy is to “plan the trade and trade the plan”.
Without proper knowledge and plan, most traders act on volatile emotions and have to suffer huge financial losses. Thus a good plan is what differentiates a successful trade from a losing one.
Don’t put all your eggs in one basket.
The principle of diversification is followed by many investors to manage the risk involved in stock trading. A well-diversified portfolio is essential to minimize risk since one can never be certain of the market action. While diversification is considered a very useful and important risk management strategy, many large investors don’t abide by its rule and try to maximize their returns by betting big on a handful of stocks.
Diversification is considered key to achieving long-term financial goals. It allows maximizing profits by minimizing risks. The main concept of diversification is to invest in different financial sectors that react to market changes or conditions differently. Diversification can be achieved by either investing in stocks of different financial sectors which are not related to each other. Investing in bonds, mutual funds, gold, real estate, and debentures are some of the options for diversification.
3. The 1-percent rule
The one-percent rule is very popular among traders in the capital market. It suggests that one shouldn’t put more than 1% of their capital in a single trade. This thumb rule limits your risk in a trade.
According to the 1% rule, if you have a total of Rs. 10,00,000 account value then you should utilize more than Rs. 10,000 in a single trade. But you can utilize more of your capital in case you see a golden opportunity to invest in the market. Traders with less account value might risk more than just 1% while those with larger account value are suggested to risk less than 1%.
4. Use of stop-loss
“The best offense is a good defense”.
A stop-loss strategy is used by traders to limit the loss by selling stocks. Stop-loss is typically executed when the price action breaks below a major support level.
Stop-loss is a powerful arsenal to cut down loss when the trade does not work out as expected.
Importance of stop-loss
Clinging to a losing stock can turn out into one of your biggest mistakes. Waiting for the stock to come back to the original price you bought can be risky. There is no promise that the stock will come back. If the stock price has to break even, it must rise by more percent than it lost which makes it difficult to come back to the breakeven point. The chart below shows how much the stock should rise after falling to get back to the breakeven point.
|Percent required to break even
If a stock declines by 50% then it must rise by 100% to breakeven. For example, if a stock lost 50% from Rs. 200 to fall to Rs. 100. It must rise by 100% from Rs. 100 to get back to Rs.200.
Stop-loss points are determined using technical analysis tools- Moving averages (5 days, 9 days, 20 days, 50 days, 100 days, and 200 days averages). It is better to apply stop-loss by knowing if the stock price has reacted to them in the past as support and resistance levels. Stop-loss can be used using technical analysis tools like RSI, Fibonacci retracements, trend lines, and MACD.
5. Take profit
Selling the stocks when they reach the target price and booking profit is an important aspect to avoid loss when there are corrections. You can sell the stocks near the resistance level and take the profits before the prices eventually decrease. Many traders have lost by holding onto a stock for far too long. Thus the art of selling at a target price is a risk management strategy.
6. Follow the trend of the market
After spotting a strong trend in the market, you can follow the trend. This is one of the most easiest and simple ways to manage risk. But one must always think on their feet in highly volatile and fluctuating market trends.
Analyzing the company before trading is of utmost priority for risk management. Determining the intrinsic value, fundamental position of the company can give an idea to an investor whether to put money on it or not. While the traders might only focus on technical signals. Companies with quality management (good leaders) usually tend to perform well. Poor management is the biggest threat that a company holds.
In a broad concept, there are four main strategies of risk management:
- Avoid it
- Reduce it
- Transfer it
- Accept it
The capital market is volatile and changes the momentum without providing any notice. Being ready for all seasons (ups and downs) is the quality of a good trader. Be it in the 2008 market crash or the 1929 market crash of Wall Street many lost huge chunks of their hard-earned money throughout their lifetime within a matter of few trading sessions. Such incidents may happen in the future too.
Thus, risk management strategy is the key to surviving the highs and lows of the market. To avoid such incidents, one must plan the entry and exist beforehand considering all the challenges put down by the capital market. Along with these strategies mental toughness (not acting on emotions) is necessary to minimize risks. In this way, you will more often than not win the trading battle.
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