Successful traders understand the importance of risk management. Trading is inherently risky because it is a zero sum game. Every rupee you gain through trading represents a loss on someone else’s balance sheet. Traders win and lose in the financial markets every day. The difference between successful and not-so-successful traders is understanding and applying a simple risk management strategy.
While risk management is a broad topic, it means one thing for our purposes here. Namely, to “cut your losses early.”
Write it down and put this phrase somewhere near your trading station. It is literally the difference between making a nice income from trading and from losing your shirt.
A losing trader has no trading plan. He hears about a stock that is destined to go up in value so he buys. Then the stock tanks about 10% and then he buys more. After all, now it’s on “sale” right? Then, the price goes down even more and the losing trader buys even more. This guy is literally paying for his ticket to the poorhouse. He clearly has no business trading stocks because he is aimless in his pursuits.
Pride is the number one reason that traders lose big money in the markets. If you can learn early in your trading career to admit when you have a loser on your hands and sell, you can go far. If a stock trade doesn’t work out the way that you had planned, sell the stock. There is nothing wrong with losing money on a trade. It happenseveryday. Instead, view your losses as your “tuition” on Dalal Street. Learn from your mistakes and try to avoid repeating them.
Know Your “Exit” Before You “Enter”
Successful traders create their own risk management strategy by determining up front how much money they are willing to lose on each given trade. In other words, before you place a trade to buy a stock, you need to set your maximum risk. Are you willing to lose 50% if the stock goes south? I hope not. That’s another sure ticket to the poor house.
There are several ways you can manage risk. First, know your personal risk tolerance. You must have a good idea of the maximum exposure that you are willing to take. Likewise, to apply that self-knowledge, you’ll need to calculate the risk of a trade before you take it. Determine the maximum amount of money that could be lost on the trade and honestly ask yourself if you are willing to accept it. If so, consider the trade; if not, walk away.
One great characteristic of the financial markets is there is always another trade. In a few hours or days, there will be another chance to make a trade that better fits your particular risk parameters. Be patient and wait for it.
A day trader, of course, generally makes a lot of trades. Therefore, day traders must manage every trade carefully. That means always using a protective stop and knowing when a loser will be liquidated. It’s not a bad idea, for purposes of risk management, to live by the cardinal rule to never trade without a stop. Bottom line, when you assume a position, place a stop loss.
Before making the trade, identify the point at which the market will make clear that the trade is wrong. For example, if buying a Nifty contract at 7955.00 and the charts suggest that support should step in at 7930.00; place a protective stop at 7929.00. The reason is simple: If that stop is hit, the market has demonstrated loud and clear that the original analysis was wrong. Take the small loss and gracefully go to the sidelines. Another opportunity will come along soon enough—and maybe immediately in the opposite direction of your original trade (see: “When to say quit,” below).
Not only do you want to know your risk tolerance, but you also want to know what to expect from your trading style. For example, if you do a lot of momentum trading, that is, you look for market opportunities when market momentum will move prices quickly up or down for a short distance, you should expect to be paid quickly. Intraday momentum trades might require profits in a few minutes if they are valid. If they aren’t showing any, check your indicators and reanalyze. If there’s no clear reason to continue the trade, exit and wait.
Do not over trade. The biggest weakness of most traders is a lack of patience. They sit in front of their computer screens waiting to trade. Because they have planned to trade, they do so. They are not discriminating enough, jumping in and out of the market continuously.
Remember, every time a trade is made, a risk is assumed. Therefore, one of the easiest ways to reduce risk is not to over trade. Have a workable and tested strategy. Know the market setup that supports that strategy and be patient. Chances are, if you are making more than five or six trades a day, then you are over trading. Take only those trades that look really good, those that meet all of the parameters of your strategy. Otherwise, the bad trades will deplete all of the money you made on your good trades.
To help end over trading, adopt this simple rule: Three strikes and you’re out. If you make three bad trades in a row, even if you manage the trades well and suffer only a small loss, close your trading platform and walk away. Something is wrong. You are off your game. Either the market is tricky and not following the rules, or some other problem exists. At any rate, do not trade in a market that is taking your money.
There’s some truth to the cliché that if you take care of the downside, the upside will take care of itself. Along those lines, always focus on preserving capital. While an all-or-nothing strategy might pay off big from time to time, it will not last in the long run. That is, if you make a trade and hold your positions until the maximum profit target is hit, you will do extremely well sometimes, but end up with nothing most times.
Trading is not easy. It demands good analysis, good execution and good risk management. Those who succeed in the game are those who manage every trade and continuously respect risk.
Balancing Fear and Greed
Psychology plays a huge role in trading. Many traders understand how to trade and could be highly profitable, but they continuously shoot themselves in the foot by being emotionally unbalanced. Regardless of your self-control, as a trader, there are two big emotions that you know all too well: fear and greed. These two forces impair analysis and keep traders from doing their best.
Greed leads to seeing money in every setup. Greedy traders trade too often and take far too many risks. Even when winning trades are made, these traders often end up losing money because they do not take reasonable profits. They want huge profits. Therefore, they keep holding positions until the market shifts and a winner becomes a loser.
The primal human emotion of greed is just one reason you should consider forcing yourself to take profits at various pre-planned levels. It keeps greed in check. It allows for a portion of the position to ride for maximum profits while taking smaller profits along the way to reduce risk and put money in the bank.
Fear has the opposite effect of greed. Traders make too few trades. They see the setup, they know it meets their criteria and is in line with their strategy, but they fear losing. Fear keeps them from making the trade and from making money.
Another aspect of fear is that it leads traders to exit winners too quickly. If one indicator goes against them, they bail. It is good to get out of losers quickly, but give yourself time to analyze what is happening. Risk management works both ways. A trader needs to get out when his risk limits are hit and needs to give each trade a chance to hit its profit target in the prescribed timeframe. A trader who is too fearful will never take risks and he will never make money. Winning traders put the odds on their side. They do their analysis, have a strategy and execute it as planned. They understand when the odds shift and are no longer in their favor and that is the time to exit the position.
Knowing your maximum downside, the most you are prepared to lose on a trade, is one of the main rules of risk management when trading stocks. Utilizing a stop loss order on each position you open will mean that your trading system and strategy removes the emotional tie to a trade, and helps to keep your trading disciplined. Losses will occur: capping those losses is a key to profitability.
When your position moves into being profitable, then you can use a stop loss to prevent profits evaporating. Many traders use a trailing stop to take advantage of increasing profits whilst limiting the downside at increasing prices.
My grandmother once told me I should never have all my eggs in one basket. It was until I started stock trading that I really understood what she meant.
It’s easier to lose money if all your funds are in a single stock, than if you have spread across several. Some win, some lose. It’s the way of the market. Even if you are trading in only one sector, then you should consider spreading your funds across several stocks.
Becoming good in different market sectors is even better: when one sector is cold, another will be hot. Diversifying isn’t just about spreading risk, it’s about creating opportunity.
Similarly, there are times when you will need to hedge your position. You may have a stock position with the results due. Taking an opposite position by way of options, for example, will mean that your position is protected over the time of the results. You can then unwind the hedge when trading has calmed down.
Some traders hedge their day trading book by taking a long position in one stock, and a short position in another ‘look=alike’ stock, hoping to profit on both.
Good trading isn’t about always picking the right stocks, or the right prices. It’s as much about managing your risk, and integrating a strong risk management philosophy into your trading strategy.