Loss is a natural part of trading but managing your risk can help protect your account from more devastating damage.
Unfortunately, it’s not just a board game.
No matter how confident investors may feel, there is always an element of risk when it comes to investing. The stock market continues to find ways to surprise us, and though we can’t always predict what may happen, we can control how much that risk may affect us.
Risk management allows traders to lose within their expectations. Instead of limitless losses, traders can use safeguards to absorb the shock of their losses.
DETERMINING YOUR RISK TOLERANCE
Understanding how comfortable you are with risk can influence the strategies you use to manage it. Determining how much capital you are willing to trade (and potentially lose), how much you research you have done on the securities, and how confident you feel with your plan can outline your tolerance for risk.
One way to potentially calculate your risk tolerance is the risk/reward ratio. This measures the potential loss versus the potential profit on any given trade.
This means dividing the potential “total risk” by the net profit, or “total reward.” For example, a risk/reward ratio of 1:3 means that for every $1 invested, a trader should aim for $3 on that investment.
The amount you are willing to risk can inform your trading plan. As you decide what you plan to trade and how much capital you plan to risk, determine your entry and exit rules for each trade. You may also use this time to prepare for a Plan B if the market conditions contradict your plan. Knowing your limits and anticipating fluctuations in the market can help you stay focused on your objectives.
WAYS TO MANAGE RISK
In addition to being mindful of your goals while trading, there are also active ways to set up defenses. These methods may vary depending on your risk tolerance or market volatility.
One Percent Rule
Many investors aim to put no more than one percent of their capital or account value in a single trade. For example, a trader with an account of $10,000 wouldn’t risk more than $100 in a trade. Though this may vary depending on the frequency of your trades or your risk tolerance, some investors consider one percent a reasonable amount for one trade.
Stop-Loss and Take-Profit
With a stop order, traders can predetermine the activation price to buy or sell a stock. This helps to limit the potential loss on a position. However, the stop price may not necessarily be the execution price in a highly volatile market, since the stop price is only a trigger for the stop order to become a market order.
Traders can limit that risk by placing a stop-limit order, or a stop order that is linked to a limit order. The stop-limit order requires the order to hit a limit price or better before executing the trade. The stop-loss point is the price where a trader will sell a stock and take the loss on a trade before the price can plummet further and increase losses.
The take-profit point is the price where a trader will sell a stock to take a profit on that trade. Traders may use this if they anticipate the price hitting a resistance level that prevents it from rising any further.
Another type of stop order is a trailing stop, which can protect gains or limit losses. The trailing stop order allows the trade to remain open as long as it is performing favorably, which can help traders continue profits.
With this order, the trader sets a certain amount above or below the market price instead of an activation price. As the price of the security moves in a profitable direction, the trailing stop price follows; however, if the security’s price moves the other direction, the trailing stop price remains the same. An order is triggered when the security’s price meets the trailing stop price.
Talking about diversification might be the most appropriate time to use the phrase “never put all your eggs in one basket.” As optimistic as one might feel about a particular security, spreading out assets over a diversified portfolio may help lower risk. Investors can consider a variety of stocks, exchange-traded funds, and real estate investment trusts as well. By investing in asset classes with a negative correlation (meaning one goes up while the other tends goes down), investors may lower their risk.