Risk management in investing
Risk management helps to limit losses. It also protects an investor from losing all his capital. Risk occurs when an investor loses money. When this risk can be managed, it offers higher chances of positive returns.
Risk management is an essential but often overlooked requirement for successful active trading. An investor who has built up a substantial profit could easily lose it in one or two bad trades without a good risk management strategy. So develop the best techniques to limit the risks of the markets. This article will discuss some simple tactics to try and protect your potential profits. Unfortunately, there are no guarantees.
Scheduling transactions
As the Chinese general Sun Tzu once said, “Every battle is won before it is fought.” This phrase implies that planning and strategy—not the battles themselves—wins wars. In the same way, investors use the phrase “Plan the trade and trade the plan.”
First of all, you need to make sure that your broker is suitable for high-frequency trading. Some brokers are focused on clients who execute few trades and therefore charge high commissions and cannot offer the right analytical tools for active investors.
Stop-loss (S/L) and take-profit (T/P) points are two important ways investors can plan ahead. Successful traders know at what price they are willing to buy and sell. They can measure the resulting return against the probability that the stock will reach their targets. If the adjusted return is correct, they execute the trade.
In contrast, unsuccessful investors trade without any idea of when they will sell for profit or loss. Losses often cause investors to hold their position in the hope of recouping their money, while profits can have the same effect but with the idea that the securities can bring even more profits.
Consider the one percent rule
Many day traders follow the so-called one percent rule. This rule states that you should never put more than 1% of your investment account capital into a single trade. For example, if you have €10,000 in your account, this means that your position in an individual instrument should never exceed €100.
This strategy is common among traders with less than €100,000 in capital — some even go for 2% if they can afford it. Traders with larger capital tend to opt for lower percentages, reasoning that as your account grows, so will your position. The best way to limit your losses is to stay under 2% — trading with more increases the chances of losing substantial portions of your account
Stop loss and take profit points
A “stop-loss” point is the price at which the investor sells his stock and takes the loss. This is often used when a trade does not go as the investor had hoped. These points are designed to prevent the “it will be okay” mentality and limit losses before they escalate. For example, when a stock falls below a key support level, investors often trade their position as quickly as possible.
A “take profit” point is the price at which the investor sells his stock and takes a profit on the trade. This is used when potential further growth is limited due to risk. For example, when a stock hits a resistance level after a strong upward move, many traders will want to sell their position before a period of consolidation begins.
Using Stop-Loss Points More Effectively
Stop-loss (S/L) and take-profit (T/P) points are often determined through technical analysis . However, analyzing fundamentals can also play a key role in timing. For example, if an investor owns a stock before the figures are announced and enthusiasm grows, he or she may sell it before the news is released and expectations are too high, regardless of whether the take-profit price is reached.
Moving averages (MA) are the most popular way to set these points, as they are easy to calculate and are widely followed by the market. The most important MA are the 5, 9, 20, 50, 100 and 200 day averages. These are best used by applying them to a chart/stock price and determining whether the stock price has historically reacted to them as either a support or resistance level
Another good way to set the S/L and T/P points is to use the support and resistance trend lines. These lines can be drawn by connecting previous highs or lows that occurred significantly above average volume. As with using MA, determining when price reacts to trends and high volumes is key.
When setting the points, consider the following:
- Use long-term moving averages for stocks with higher volatility to reduce the chance that an insignificant price change will execute the stop-loss order.
- Adjust the moving averages to match the price range you are targeting. Larger ranges should use larger averages to reduce the number of signals generated.
- Stop-loss should not be set closer than 1.5 times the high-low range, as it will likely be executed too quickly for no reason.
- Change the stop-loss according to market volatility. If prices do not fluctuate much, the stop-loss points can be set tighter.
- Use known fundamentals such as quarterly earnings releases to decide whether or not to enter a trade as volatility and uncertainty normally increase.
Calculate expected return
Stop-loss and take-profit points are also needed in calculating the expected return. The importance of this calculation cannot be stressed enough, as it requires investors to think carefully about their trades. It also provides a systematic method to compare different trades and choose only the most profitable ones.
The following formula can be used to calculate the expected return:
[(Probability of Profit) x (Take-Profit % Profit)] + [(Probability of Loss) x (Stop-Loss % Loss)] = Expected Return
The result of this calculation is an expected return for the active investor, who then weighs this against other possibilities and decides what to invest in. The probability of profit and loss can be calculated using historical figures on breakouts and breakdowns of support or resistance levels — or for experienced investors, by making a well-considered estimate.
Diversify and Hedge
To get the most out of your investments, never put all your eggs in one basket. If you put all your money in one stock or instrument, the chances of a big loss are very high. So remember, diversify your investments — this can be at different levels, from sector to entire market or geographically. This not only helps to hedge your risks, but also opens up new investment opportunities.
There are also times when you may find that you need to hedge your positions. For example, you may have a position in a stock that has a known performance. You may consider taking the opposite position using options, which will help protect your positions. When the market activity subsides, you can close your hedge position. Plus500 does not offer hedging and swing trading.
Put options
Buying put options , also known as a “protective put,” can also be used as a way to hedge your potential losses should a trade not go as planned. A put option gives you the right, but not the obligation, to sell your position at a certain price before or after the option expires. For example, if you own $100 of stock XYZ and you buy a 6-month $80 put for a $1.00 option premium, you are protected from any price drops below $79 ($80 strike price – $1 premium).
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