Risk management means identifying, assessing, and mitigating the risks of losses in any investment. To attain success in trading, the trader must know how to avert the risk of bearing losses. Risk management techniques in trading are steps to shield yourself from severe losses. These strategies or techniques differ according to your situation and kind of trade.
This article will discuss some key techniques to minimize losses if the stock market tide turns against you.
What Is Risk Management and Why Is It Important?
Risks of losses arise when the stock market shifts in a way you had not expected. This can be because of political, economic, or business events like the emergence of new technologies.
Risk management implies the techniques you employ to safeguard your trading capital. It, in turn, lets you make a profit. It doesn’t take more than one or two bad trades to make a trader lose all the profit they have generated. It is here that incorporating risk management techniques in trading helps.
The strategies cut losses and prevent the situation from getting out of control. The usage of risk management tools like stocks and limits allows traders to gain an advantage from the upside movement of trading. At the same time, it minimizes downside risk.
Keep reading to learn top tips and strategies to manage risk.
Best Risk Management Techniques for Traders
Here are some of the most effective risk management techniques for successful trades.
1. Portfolio optimization
Portfolio optimization is the process of creating such a portfolio that increases the expected return and reduces risk. It is based on the MPT or the Modern Portfolio Theory. This principle operates on getting the highest return at minimum risk. To this end, a portfolio should have assets that are only chosen after factoring in their performance relative to one another.
In other words, the assets should have less correlation with each other. This allows the investor to remain largely unaffected if a specific asset lowers in value.
It is an investor’s risk management strategy that entails selling or purchasing an investment to minimize the loss risk of the current position. This technique is usually executed at a point post the initial investment. Investors do not hedge a position at the beginning when they are buying a stock.
Hedging mitigates losses for a current trade in the scenario that it moves in the direction you don’t want. This strategy is facilitated through financial instruments like futures, options, and forward contracts. Common hedging techniques include the following:
- Usage of options to safeguard against downside risk.
- Being a part of futures contracts to hedge the price fluctuations of hedge commodities.
- Using currency swaps to hedge the exposure to foreign exchange.
- Using interest rate swaps to deal with risks of interest rate.
3. Stop loss
Stop loss means a buy or a sell order, which is prompted when the stock rate reaches the stock price (specified price). It is one of the risk management techniques in trading beneficial for investors who don’t desire to track the security regularly.
Suppose you purchase stock at $50 per share. You fear that its price will drop. So, you can choose a stop order to send if the rate drops below $40 per share. Thus, it will secure against a bigger loss.
4. 1% risk rule
The 1% risk rule is a common risk management method for day traders. It means that you never risk greater than 1% of your account value. You do it by trading either big positions with tight stop-losses or small positions with stop-losses that are far from the entry price.
Traders can employ all of their capital on one trade. Using this rule implies that you can prevent losses of more than a percent on a specific trade. This strategy protects your capital from dwindling significantly in bad situations.
As an example, consider you have a $10,000 account. With this strategy, you will only lose an amount of $100 (1%) on a single trade.
5. Manage risk through a positive ratio of risk to reward
A positive risk to reward ratio helps in managing risks in the long term. It increases the consistency of your account. The risk to reward ratio determines the number of pips (Point in Percentage) a trader can risk over how many pips he gets on achieving the target.
The pip measures the minutest value change between two currencies. For example, if the ratio is 1:2, it implies that the trader risks one pip to make 2 pips. Repeatedly using this technique gives you profitable results. Moreover, traders can still achieve success even if they win just 50% of the trades but maintain a positive ratio.
6. Algorithmic trading and back testing
Monitoring trades is crucial to improve the return. The techniques mentioned below will help you effectively monitor your trade.
A. Algorithmic trading
It employs a computer program that adheres to certain algorithms to trade. These algorithms or instructions are based on price, timing, or other mathematical model. This type of trading makes way for more systematic trading as it eliminates the effect of human sentiments on trading. Some common strategies include arbitrage opportunities, trend-following strategies, and index rebalancing.
B. Back testing
Back testing implies testing a strategy on past data to evaluate its accuracy. Traders use backtesting to determine a strategy’s likelihood of performing in the current market. This technique is based on the assumption that trading strategies that gave good results earlier will give similar results in the future.
7. Trailing stop
A trailing stop is an order type to safeguard games by letting a trade stay open. It enables the trade to continue to profit until the price shifts in favor of the investor. The trailing stop closes the trade when the price’s direction shifts by a particular percentage.
This risk management has greater flexibility than a stop-loss order because it tracks the direction of stock price automatically. You don’t need to reset it manually like the fixed stop-loss.
To use it successfully, set it as a neither too tight nor too wide level. If you place too tight, the order will be triggered by usual daily market movements. On the other hand, a very wide trading stock won’t be triggered by usual market movements. But the trader will take the risk of unnecessarily large losses.
Use these risk management techniques in trading to make your profit larger and your losses smaller. Every trader is different and needs a specific combination of tactics. So, combine these techniques with your trading plan for the best outcome.