Beginner’s Guide to Risk Management

Thu Mar 25, 2021, 11:36 am | by Charles Munyi | No comments

We face risks every day. Take driving to the grocery store or work, and a crash could occur at any moment. You could avoid this risk altogether by ordering out or working from home. The same applies to active trading — it’s a fast-paced trading style that often calls for experience, discipline, and strong risk management skills. Unfortunately, risk is often misunderstood. Not all risk is bad — and if you’re smart with it — it can be a useful tool in your finances and beyond.

When you avoid taking risks in trading, you’re accepting a lower level of potential return in exchange for a potentially higher level of stability and security. It’s impossible to control the stock market’s movement, but you may have a hand in managing the risk of loss with the trading choices you make.

What is Risk Management and Why It Is Important

Risk management is a crucial but often overlooked prerequisite to successful active trading. It helps reduce losses, not to forget protecting your trading account from losing all its money. By managing your trading risks, you simply open yourself up to making more money. After all, you could lose all your profits by making one or two bad trades. That’s why you need a solid risk management strategy.

Most successful traders often quote the adage; “Plan the trade and trade the plan.” Planning ahead of time may be the difference between success and failure in your trading. The first step in managing your risks is selecting the right broker. Some brokers may offer a ton of research, educational, and analytical resources at the expense of high fees and commissions. Others may have no minimum account requirements but at the expense of limited exposure to the stock market. Ultimately, it’s a trade-off you must make, so be sure to pick a broker that matches your investment goals and preferences.

Risk management is also a crucial aspect of trading psychology. Trading without the appropriate risk management strategy means that you’ll enter trades without an idea of when to exit in order to take profits. As a result, emotions will start taking over and dictating your trades, which may result in streaks of luck and misfortune.

Losses will often provoke the trader without a plan to hold on in the hope of making their money back. On the other hand, profits may entice a trader to imprudently hold onto a stock for more gains even when a downturn is imminent. Without the right risk management strategy, emotions cloud your judgment and you rarely take the time to utilize technical indicators in analyzing the stock market.

Ultimately, risk management is supposed to help ensure that capital is utilized wisely, and profits are made while minimizing losses. It must also be a top priority for active traders looking to protect and grow their investments. Just be sure to understand your risk tolerance and craft a risk management strategy around it. And as a rule of thumb, never trade money you can’t afford to lose.

The 1% Rule

Traders who are familiar with risk management will understand the 1% rule as the risk-per-trade. It’s simply the maximum amount of risk you’re allowed to take per single trade. For simplicity, the 1% rule only allows you to risk up to 1% of your trading account per single trade. While your overall risk shouldn’t go beyond 1% of your trading account under this rule, it’s okay to risk a lower amount — but this often comes down to the size of your account.

The 1% rule is meant to help you avoid large losses on single trades, letting you remain in the trading dance for a longer period. Think of a trade that dings your trading account by 50% — you would need a 100% return on future trades to break even. And this is the main reason why rookies don’t become consistently profitable traders.

Here’s an example of the 1% trading rule. Let’s say ABC stock is trading at $20 and you want to enter a long position. With $10,000 in your trading account, you know that the total risk per this trade shouldn’t exceed 1%, which equals $100.

How to Calculate Your Position Size

Position size refers to the number of units within a portfolio that you invest in a specific security. You must consider the risk tolerance and account size when determining the position sizing. Position size helps investors determine how many units of a security they can buy, which helps in controlling risk and maximizing returns. Calculating your position size requires you to weigh several factors:

  • Account risk. You must determine your account risk before using the right position size for a specific trade. This is often expressed as a fraction of your capital, and most retail investors won’t risk anything in excess of 2% of their investment capital on a single trade. For a single trade, if an investor holds an $18,000 account and sets their maximum account at 2%, they cannot risk more than $360 per trade.
  • Trade risk. Investors must then establish where to place a stop-loss order for any specific trade. With regard to stocks, the trade risk is the gap, in dollars, between the entry price and stop-loss price. For instance, if you intend to buy a stock at $100 and place a stop-loss order at $90, the trade risk is $10 per share.
  • Proper position size. You now know that you can risk $360 per trade and are risking $10 per share. You can use this information to work out the right position size — divide the account risk by the trade risk (360/10), which is 36. This means you can buy 36 shares.

Stop-Loss and Take-Profit Points

A stop-loss order is one of the most effective ways for protecting yourself against the risks of a volatile trade or market. If you know how to use them correctly based on the nature of the security you’re trading, you can effectively protect yourself against inefficient trading or losses.

To get started with stop-loss and take-profit points, you must set a threshold for your trade, which is simply the maximum amount of money you’re willing to lose on a trade before selling. However, settling on the triggers for your threshold requires some level of knowledge since some stop losses may work better in some situations, for instance by acting as automated blockers that let you protect your investment up to a reasonable point.

It’s advisable that you always take into account the previous trends in the security over the past week and review any news you can find regarding the stock before deciding how to place the stop loss and at what price you’d like to set it.

With the right market information, you’ll also be in a better position to pick accurate and realistic take-profit points, otherwise, your orders will never execute.

Whether they are stop orders with your brokerage or orders inherent in your trading system, they should be there.

Diversification

Sure, all investments carry some level of risk, and as a result, you can avoid it altogether. Fortunately, diversification, a strategy used by investors to manage risks can help avoid the over-exposure to one particular area. By spreading your capital across various sectors and assets the logic is that should one area experience turbulence, the others should be strong enough to bail it out. You can spread your money between companies of different sizes, sectors, and different geographical regions.

Final Thoughts

It’s important to have a solid strategy when it comes to risk management. Even when you have no control over market movements, avoiding taking risks in trading simply means you’re accepting a lower level of potential returns at the expense of better security and stability. 

To help in mitigating your investment risk, always look for a combination of ways to avoid, manage, and transfer the risk. You may also consider working with a financial planner who can design an investment plan suited for your individual goals, risk tolerance, and situation.