How to manage risk to be a successful trader
One thing that separates a profitable trader from a successful trader is the Risk Management. The most underrated and overlooked, but an essential prerequisite for a successful trading career.
In this blog, I will be telling you how to manage risk and remain profitable in long run.
Hi, this is Parshuram Desai, and lets talk Risk Management.
There are may traders out there who are making good money in stock market but there are very few who can retain their profits in long term.
Making money in stock market is not easy. Stock market has very bad reputation when it comes to making money. Many... many... many traders and investors have lost their capital. Few who could make profit eventually loose it with time. Making consistent profit is not enough to be a successful trader.
"Making consistent profit and retaining the profit is what differentiates a successful trader from a profitable trader."
The question is How to retain the profits? and the answer lies in Risk Management.
What is Risk Management?
Risk Management is the process to identify the risk, assess the risk and develop a strategy to manage and minimize the risk while maximizing the returns.
Let us divide it into three parts.
1) Identify the risk.
Like any other business, investing and trading also has its own associated risk. Identify all the possible risk associated with your investing / trading system.
For instance, a trader who has bought put option will loose money if stock price rises, or volatility decreases or due to time decay. Hence for a put option buyer the risks are rise in stock price, decrease in volatility and longer time duration.
2) Assess the risk.
Once the risk factors are identified the next step is to quantify the risk. Calculate how much will you loose. A trader has to do "what if analysis" of all possible scenarios and analyze what could be the possible outcome in case of worst case scenario.
One can use simple excel model to analyses option strategies. However advance analysis tools are available to analyze complex option strategies which involves multiple options in different expiries.
3) Develop a strategy.
Once the risk is identified and analyzed the key is to formulate a strategy that targets the risk and minimizes it.
For instance, Covered Call is an excellent strategy with a potential to make huge money for a trader. However the things can easily go out of control in case of black swan event, which will wipe out all the profit that this strategy has generated. Hence it is very important to manage this risk.
There are many tools that can be used to manage the risk. Below are some of them.
1) Diversification
Diversification is one of the important factor in minimizing risk. Different sector react differently to the same event. Diversifying the trading activity in different sectors will reduce the risk as compared to trading in one sector or in one stock.
2) Stock Selection
Stock selection is very crucial. It is always recommended to do your research before picking up a stock for trading. A fundamentally strong, large cap stock with proven track record has less chances of bankruptcy as compared to small cap with poor fundamentals.
3) Position sizing
Position sizing is all about knowing how much capital a trader is willing to risk, out of the total capital. many traders use standard 5% rule for position sizing, that means a trader is willing to risk not more than 5% of his capital on a particular trade. However a trader should not randomly select predetermined position sizing for all traders. A trader should look for a major support or resistant level and depending on the volatility of stock should define a stop level. Based on this stop level trader should define the position sizing of trade.
4) Hedging
Hedging is like insurance, where in a trader pays a premium amount to buy an insurance and transfers his risk to insurance seller. Hedging typically involves taking an opposite position corresponding to an existing position. For example an call option seller, offsets his unlimited risk by buying higher strike call option.
5) Stop Loss
Stop loss in a tool used by many day traders. Stop loss strategy is used to avoid excess loss when the trend goes against the traders view by automatically exiting the trade when stock price reaches the predefined stop loss level. For example setting an stop loss order 2% below the buy price will limit the max loss to 2% of investment.
6) Fire Fighting
Fire fighting is mostly used by option sellers when market moves against the predicted direction. If a trader has sold put option and market starts falling, he will start selling higher number of call option to collect more premium. This strategy involves high margin and a trader has to keep aside additional funds for fire fighting.
Why is it important?
1) To contain the emotions
Fear and greed are the two biggest enemies of a trader. To be a successful trader one has to control these emotions. Risk management prepares the mindset to fight these emotions, which also gives him an edge over others traders.
2) To make persistent money
Market doesn't always moves in predicted direction. When market moves against your view it is important to manage the position and come out profitable. Risk management averts losses, protects the capital and even make money.
3) To avoid big losses
Markets are uncertain. Black swan event can happen any time. It is always a good idea to protect the capital all the time. When black swan event do happen, Risk Management will cut-off the huge losses and protect the capital. Remember small profit is better than big loss.
"Risk Management is the key to success in any form of trading"
Conclusion
- To be a successful trader, one has to include risk management in his trading plan.
- Identify the risk, assess the risk and develop a strategy to manage and minimize the risk while maximizing the returns.
- Diversification, Stock Selection, Position sizing, Hedging, Stop Loss and Fire Fighting are some of the tools used for risk management.
- Risk Management is important to contain emotions, to make persistent money and to avoid big losses.
- Remember, if you don't invest in risk management, it doesn't matters what business you're in, it's a risky business.
Put your doubts & thoughts in comments below.
Happy Trading.
Disclaimer:- The article is for educational purpose only. Please consult your financial advisor before making any investment decision.
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