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Basics of Risk Management 

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Basics of Risk Management 

Basics of Risk Management 

7.1 The basics of risk management

Risk management is a crucial skill in any trader or investor’s toolkit. It revolves around scanning for factors that can have negative effects on trades, and reducing their impact as thoroughly as possible. 

Proper risk management is the fundamental distinction between trading and gambling. While investing and trading inherently involve carry a degree of risk, the recognition and effective management of these risks distinguish a successful trader from someone who merely gambles on speculative trades.

7.2 How does risk management in stock work?

In stock trading, risk management is performed by setting a series of rules and actions that protects against the downside of a trade.

However, the idea is not to avoid risk altogether, instead, the aim is to minimise risks while maximising potential returns.

But how do you manage your risk if you don’t know what they are, or where they could come from? 

That’s an excellent question, and points to the crux of the matter – risk management is about understanding what you are doing, the likely consequences of your choices, and what to do (and not do) in order to maximise the chances of a favourable outcome. 

7.3 What risks should stock traders look out for?

Liquidity risk 

Liquidity in stock trading refers to the ease and speed with which one can buy or sell a stock without significantly impacting its price. This is influenced by how frequently the stock is traded.

Not all stocks offer the same level of liquidity. For instance, blue-chip stocks typically have higher liquidity compared to small-cap stocks or those from emerging markets.

Stocks with lower liquidity can experience wider bid-ask spreads (the difference between the buying and selling price), which can reduce profits or increase losses.

Additionally, executing orders in less liquid stocks might face delays, potentially leading to less favorable trade outcomes. In extreme cases, there might be difficulty in finding buyers or sellers for a particular stock.

Check out a more in-depth article on market liquidity.

Broker risk

This is related to the capabilities and technology of the brokerage platform you use. Broker risk ranges from the quality of the trading software provided, to connection stability and speed, and anti-fraud and account safety measures. 

For this reason, it’s important to pick a reliable and trustworthy brokerage. 

Market risk 

Market risk refers to the volatility of the stock market, which can be affected by a number of events. Some examples are political instability or upheavals (such as unexpected election results), economic issues such as recession or interest rate spikes, or international relations, such as trade tariffs or wars.

Country and social risk

Stocks are closely tied to the countries where the issuing companies are based, making it important to consider the overall situation of these nations, including political, financial, and social stability.

Country risk in stock trading arises from investing in a specific company within a particular country, which may be subject to unique conditions or restrictions impacting investment outcomes.

Social risk can emerge when a country faces challenges to its social stability, such as uprisings, demonstrations, and civil unrest. These events can negatively affect the stock market and the valuation of companies within that country.

7.4 How stock traders can manage risks

Proper use of leverage 

In simple terms, leverage means borrowing from the broker to trade a larger position in a stock. This can multiply the returns on a winning trade; but on the flipside, losses are similarly amplified.

For example, with a leverage ratio of 100:1, you might only need to invest \$1,000 of your own money to control a \$100,000 position in a stock.

Let’s say the price of the stock moves by \$1. In a leveraged position, this \$1 movement is amplified. If you’re controlling 100,000 shares, a \$1 movement equates to a \$100,000 change in value.

Consider a scenario where instead of buying 100,000 shares, you opt for 10 smaller lots of 10,000 shares each. If the stock price drops by \$1 across all 10 lots, your total loss would be \$10,000.

In contrast, trading without leverage and buying only 1,000 shares, a $1 drop in stock price would result in a \$1,000 loss.

The same principle applies to profits: with leverage, a \$1 gain per share could lead to a \$100,000 profit, whereas without leverage, the profit would be \$1,000.

Leverage is indeed a powerful tool in stock trading, acting much like a double-edged sword. It’s crucial for traders to select an appropriate level of leverage and be fully aware of the potential losses if the trade doesn’t go as planned.

Proper allocation of trades

Another essential risk management technique is making sure to choose proper allocation of trades. 

What this means is that the capital at risk for each trade you make should not exceed a certain percentage of your overall capital – before leverage. By adhering to this principle, traders can limit their exposure to extreme losses in case of an unfavourable market movement in one or a few positions.

This approach enables investors to maintain a balanced portfolio, allowing for more stable long-term growth and reducing the potential for overinvesting.

Setting stop losses

A stop loss is a trigger point at which your trade is automatically closed, taking any loss or profit at that point. 

This is a simple yet powerful way to manage your risk as it prevents you from giving in to negative emotions such as greed, which may cause you to stay in a losing trade and end up with more losses.

As stop losses are decided ahead of time – you choose the price level at which the stop loss will trigger – they are ideal for keeping you on track. They can also help save your trade from unexpected market movements that occurred while you were unable to respond, such as overnight.

Note that stop losses are not 100% foolproof. During moments of extreme volatility, your stop-loss order may fail to be filled by the market, which means your position will remain open. 

Nevertheless, stop losses prove to be valuable tools and traders should familiarise themselves with their use.

Taking profits 

Another often-overlooked yet essential skill is knowing when to take profits. This means being able to discern the most appropriate time to close a profitable trade so as to lock in your profits in your account. 

While it can be tempting to ride a profitable trade all the way to the end, the speed at which the stock market moves can make this easier said than done. 

Just like with stop losses, you can set a take profit order to help you automate your profit taking and better manage your trades.

7.5 Understanding Risk-reward Ratio 

An essential concept to master in stock trading (and trading in general) is the risk-reward ratio. 

Of course, different risk-reward ratios have different probabilities of success; a ratio of 1:2 happens far more often on average than a ratio of 1:10. 

Another thing to note is that risk-reward ratios are not set in stone. Rather what is considered an appropriate ratio depends on timeframe, trading environment, entry and exit points and trading strategy used. 

You can calculate your own risk-reward ratio by using the following formula:

  • R/R Ratio = (Entry Point – Stop Loss Point) / (Profit Target – Entry Point) 

7.6 The Importance of a Trading Plan

We’ve gone through many different aspects of risk management in this module. How do you bring it all together and keep track of it all? That’s where a trading plan comes in.

A trading plan is a codified set of rules and decisions you lay down for yourself as a template to guide your trading journey. Think of it as a systematic method for identifying trading opportunities. 

A trading plan contains a basis for making trading decisions based on proper research, and taking into account various factors such as time, risk profile, market sentiment and investor objective.

This is an important tool that will help keep you on track with your goals and stick to trades with a sound foundation. 

Additionally, consider expanding your trading plan to include a record of your trading experiences, learnings and outcomes – a sort of trading plan/journal hybrid, if you will.

In this way, your training plan can evolve along with you, as you learn new skills, develop trading strategies, and formulate and test new trading strategies. When you find that your previous assumptions no longer hold, you may update the trading plan with your new findings. 

A trading plan is also a great way to build discipline and learn from your experiences. You should detail each trade you make, including important information such as entry and exit price, capital at risk, profit or loss and return on investment. 

Finally, your trading plan or journal will only be valuable to the extent that you make use of it. Please make sure not to overlook updating your trading plan even if you start gaining confidence as a trader.

Quiz

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Module recap

  • Risk management is an essential skill that stock traders must master. It involves scanning for factors that may negatively affect trades and taking steps to minimise their impact.
  • The crux is to minimise risk while maximising the potential for returns.
  • Proper risk management is what sets a professional trader apart from someone who simply gambles on the stock market. 
  • Liquidity risk arises when a stock has low trading volume. This can cause high spreads, or even prevent trades from being executed altogether.
  • Broker risk depends on the technology, capabilities, policies, and safety measures of the brokerage you choose.
  • Market risk refers to the volatility of the market and can be impacted by economic or political issues.
  • Traders should also be aware of country and social risks that may be at play in the countries whose currencies they are trading.
  • To manage risk, proper use of leverage is crucial. Be aware that leverage multiples your potential loss, which may outstrip your account value.
  • An important risk management strategy involves selecting the right allocation for trades, ensuring that the capital risked on each trade does not surpass a specific percentage of your total capital before leverage. This percentage can vary based on your individual risk tolerance.
  • Learn how to set stop losses to reduce potential losses and improve your trading outcomes.
  • Taking profit at appropriate levels can give you better results over the long run versus attempting to ride out every trade.
  • Understanding risk-reward ratio is crucial to your success. Risk-reward ratio varies from trade to trade, and you can calculate your own ratio for each trade.
  • A trading plan is an integral tool for risk management. It serves as a record of your trading outcomes, helps you to learn from past mistakes, and may help detect unconscious biases or negative beliefs that are hindering your success. 
Basics of Risk Management