5 Risk Management Techniques for Traders
A stock trader
Stocks have always been a popular investment vehicle for most people. They’re an excellent way to overcome inflation while protecting your money’s value. Historically, people have had varying approaches to the stock market.
Two types of stock investing exist, including passive and active investing. Passive investing refers to people who invest in the stock market seeking long-term gains. They hold long-term positions, typically ranging between five to ten years, if not longer. On the flip side, you’ve got active investing that refers to people who like trading stocks on a short-term basis. Active and passive investors share a similar goal – to profit from holding stocks. However, the duration differs. Active investors will typically hold stocks for days or weeks.
Whether you’re an active or passive investor, you’ve likely heard countless tales about people losing their money by making poor investment decisions. The reality is that if you’re investing in financial markets, you have to be careful. Otherwise, you’ll rack up significant losses. New traders often don’t understand how to protect their money. They’re so obsessed with chasing profits; they forget about minimizing risk.
Risk management is a crucial principle that all traders and investors must know. Risk management can help you reduce losses while protecting your account from losing capital. The reason traders need to manage risk is they never know when a trade might not go as anticipated. Even the most experienced and seasoned traders have bad days where their trades fail miserably. If you were all-in on every trade you made, you would lose all your hard-earned money on a single trade, and as a result, you would find yourself starting from scratch with lower investment capital. Hence, managing risk is crucial. We’ve prepared some tips to help you manage your trading and investing risk.
A stock trader assessing charts
Risk Management Techniques for Traders
Here are some risk management techniques beneficial for traders. They include:
Plan Your Trades
The first step for managing risk involves planning your trades. For starters, you’ll want to ensure you’re using the right broker for your trading activities. Some brokers cater to infrequent traders, while others are more suitable for active traders. Find the right broker for your needs. If you’re an active trader using a broker who caters to infrequent traders, you might have to pay high commission fees. In addition, they might not provide you with the proper analytical tools needed to take a position and place your trades.
Use the One-Percent or Two-Percent Rule
Most experienced day traders are huge proponents of following the golden risk management rule. The golden risk management rule refers to using one percent or two percent of your capital for a single trade. Following this rule can help you minimize your risk and preserve your trading capital. For instance, let’s assume you have $10,000 in your trading account. You spot a trade you think will be profitable and you want to invest. If you invested $5,000 in a trade that didn’t go as anticipated, you would instantly lose half your trading capital.
That’s why experienced traders suggest following the one or two-percent rule. If you followed this rule, you would only invest $100 or $200 in a single trade. Even if your trade wasn’t successful, you wouldn’t lose a significant part of your trading capital. As a result, you’re managing potential losses better. Most traders recommend sticking with the one-percent rule. However, if you’ve got significant trading capital – typically exceeding $100,000 – you might want to consider using the two-percent rule.
Set Stop-Loss Points
Stop-losses are an excellent and often overlooked way to minimize risk. A stop-loss point refers to a price where a trader will sell their stock, taking a loss on it. To illustrate, let’s use an example. Let’s assume you purchased XYZ stock for $30. The stock dips to $25, and trends show it will continue to depreciate until $10. You already know this is a trade gone wrong because it doesn’t pan out in line with your expectations. Your best bet would be to reduce your losses. You can set a stop-loss limit at $24. If the stock’s price dips below this point, your broker will sell your stock automatically. Doing so will prevent you from incurring any further losses.
In addition to stop-losses, you might also want to consider using trailing stops. Trailing stops apply perfectly to long and short positions. Let’s assume you purchase a stock, and its price rises. Your trailing stop will rise with the stock’s price, enabling you to generate returns on your stock. However, let’s assume your stock’s price decreases. In such instances, the trailing stop remains put and prevents you from incurring any significant losses.The trailing stop works similarly for short positions as well.
Diversify and Hedge Your Bets
Diversification is one of the most effective ways to minimize risk. Ideally, you don’t want to put all your eggs in one basket. Therefore, ensure that you don’t have all your trading capital invested in a single stock. Instead, you’ll be better off diversifying your stock portfolio. You might want to consider investing in different industries. In addition, you’ll also want to invest in stocks of companies of varying sizes. Most people often gravitate towards large-cap stocks. However, you might also want to give small-cap and micro-cap stocks a try.
In addition to diversification, you might also want to hedge your position. You can hedge by taking the opposite position via options. Traders commonly use put and call options to hedge their bets against a stock.
Perform Position Sizing
Performing position sizing can help you minimize risk as a trader. If you properly position size, you can avoid drawdowns while maximizing your profit. Numerous different models exist for position sizing, including the Kelly Criterion model. The Kelly Criterion model is one of the most commonly used position sizing models by investors and traders. That’s because it enables them to calculate how much capital they’re wagering on a particular outcome. In addition, you can also use adequate position sizing to manage risk t for your overall portfolio.
Facebook stock chart on a smartphone screen
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