Risk Management

Risk Management

Risk management is absolutely critical in the success of an active trader. Without prudent risk management, it is very possible for trader to lose their entire account in just a couple of trades. Risk management helps you understand the potential downside to every trade and make informed decisions on each trade you take.

To start with basic risk management, a trader needs to understand the concept of support/resistance lines, stop-loss and profit taking. In essence, risk management is about calculating the probability of winning and making the soundest trading decisions. A good trader will need to know where to enter a position and where to exit a position. If the potential reward when compared to the potential risk is favorable enough, the trade is executed.

To a new trader, an easy way to determine this is by looking at the support and resistance line. For example: In a long scenario, the difference between the current price of the stock to the next line of support versus the difference between the current price of the stock to the next line of resistance is called the risk/reward, or R/R ratio. As you probably might have guessed, a low risk and high reward ratio makes a favorable trade. A general rule of thumb of a good trade is 1/3. If the stock price drops below your designated line of support, you would sell the stock immediately, and if the stock price hits your target at the line of resistance, you will cash out and take profits. Another popular way of setting R/R is using a pair of Moving Averages, or MA.

Not all trades you take will hit your profit target

In fact, only a small percentage of the trades will, and for those that do not, you will have to cut losses immediately. To enforce this, traders often use stop-loss function to liquidate their positions immediately. The stop-loss is triggered automatically by your broker. Keep in mind though, if you have a DRIP set up, you will no longer be buying the fractional shares as you have sold the security!

Understandably, many traders do not feel comfortable with taking a loss and therefore, do not adhere to the cut-loss point 100% of the time. The stop-loss insures that this does not happen and a loss will always be cut before it gets out of hand.

Overall, the strategies used in making your trades can vary greatly and the examples mentioned here is by no means a hard rule. The key is that you have a very clear idea of when you will enter and when you will exit a trade. Effective risk management involves having a clear idea about the risks involved and ensuring that you do not break your rules.

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