Importance Of Risk Management In Trading
Importance Of Risk Management In Trading
Risk Management is one of the most
important pillars of successful trading. Key Points regarding Risk Management:
The Concept of Risk Management in Trading:-
Risk-to-Reward Ratio :-
The above example establishes the importance of
the risk-to-reward ratio in trading. The risk-to-reward ratio is nothing but
the Risk taken for every rupee earned. Let’s take the above example; let’s say
a trader aims for 100 rupees profit and takes the Risk of Rs.50; then, in that
case, the risk-to-reward ratio is 1:2 (Risk – 1: Reward – 2), which is a good
risk-to-reward ratio.
Generally, trades with good risk-to-reward ratios, such as 1:2 or 1:1.5
or 1:3, are preferred rather than the trades that offer bad risk-to-reward
ratios, such as 1.5:1 or 2:1 because you are risking more money than you would
potentially make. Therefore, you should never take trades with bad
risk-to-reward ratios. This is the most fundamental rule of risk management in
trading.
Principles of Risk Management in Trading
By now, you must have understood the importance of Risk management in
trading. Now, we will see how we can apply certain risk management principles
while trading so that you, as a trader, can make consistent and long-lasting
profits.
There are some fundamental rules of trading that every trader must
follow while trading:
Define
Percentage of Risk
Do not
lose more than a specific percentage of the amount: this is a fundamental and
the most effective way to control your losses as a trader. To become a
profitable trader, you must cut your losing trades and hold your winning
trades.
By predetermining your Risk, you work
to eliminate the possibility of a big loss , and that is how you win in the
long term. For example, let’s say that you are trading with Rs.1 Lakh account,
and you take a 2% risk on every trade. So, you only risk Rs.2,000 on every
trade, including brokerage, taxes and other charges. This is how the 2% rule works
in trading. Also, it is not mandatory to only risk 2%; you can also increase or
decrease the percentage of Risk you take, depending on your trading style and
the reward you are aiming for.
Using a Stop-Loss
Whenever you place a trade, it is mandatory to place a
stop-loss. Without a stop loss, trading is like a vehicle with failed brakes
which is bound to crash sooner or later. Stop-loss saves you from big losses
that can blow your trading account in a single trade. As we say, in trading,
being wrong is not a mistake, but staying wrong is. So, when your stop-loss
gets hit, you should always accept that stop-loss without any emotional
barrier.
Some traders place stop loss in a system, and
others place stop loss in their mind, and when they see their stop loss is
hitting, they exit the trade without any hesitation. As a beginner trader, one
should always place their stop loss in a system as initially; a trader may not
have the right trading psychology and courage to exit the trade at the
right time.
Position
Sizing
Position sizing is nothing but the quantities of shares or
contracts you want to trade. Position sizing is totally based on the amount of
stop loss and the amount of capital you want to risk in a particular trade.
The formula for position sizing is Risk
per trade (Amount) / Stop loss value. Let’s say your Risk per trade is
Rs.2000, and your stop loss is Rs.10. In that case, if we divide 2000 by 10, we
get 200. So, in this case, you cannot trade more than 200 quantities in that
trade. This is how position size is calculated to manage your Risk each time.
Target Setting
In trading, we make money at the exit. So, knowing the
best time to exit the trade is important. In order to become a profitable
trader, you should place your stop loss and target logically.
Also, using a trailing stop-loss is a must so that you
can manage your Risk timely and come out with some profit.
Many people do not use trailing stop loss ,
converting their winning trade into a losing one. You need a perfect exit strategy
to tell you when to exit your trade. Generally, traders do not use any exit
strategy, and this, usually, is the biggest lacuna in their risk management
strategy because if you do not know when to exit the trade, then it will be
almost impossible for you to make consistent profits.
The Real Importance of Risk Management in Trading
Let’s take a look at a practical example of how risk
management plays an important role in trading. Consider two traders, one
follows some risk management rules like 2% rule, trailing stop loss etc., and
the other does not follow any risk management principles .
Now, let’s say they have a losing streak and have
consecutively lost 5 to 6 trades. Because of risk management rules, the first trader
only loses 10% to 12% of the account, while the other trader may blow his
entire account in just 5 to 6 trades. This is how risk management saves your
capital erosion.
However, just setting risk management rules for
yourself is not enough, you also have to follow them religiously to see good
results. Often, many traders set rules for themselves but do not follow them
because they let their emotions get the better of them, and emotions are the
enemy of good trading.
Risk Management Techniques for Options Traders
Options are high-risk and high-reward trading
instruments, and it isn’t easy to trade in them because they contain a lot of
risks and are quite volatile when compared to equity trading.
Hence, in options, there are some basic risk
management principles which you should follow.
Another important thing to understand is, if you are
new to trading and haven’t traded in equity, you should first try trading in
equity and becoming profitable for a couple of months. Once you are familiar
with the basic trading rules, only then should you try options trading with one
or two lots.
Now, we will discuss some risk management rules you
can use while trading options.
As an option buyer, you should only 25% to 30% of your
capital in a single trade. The most common mistake that most options buyers
make is using their entire capital in one trade and trading in heavy quantities
with the hope of greater profit.
Another risk management rule for option buyers is
never to trade out of-the-money options, especially on an expiry day. Many new
traders try to trade these Out of Money options, and most end up losing money.
They think they are cheap options and will be less risky, but in reality, the
situation is exactly the opposite. Most of the Out of Money Options tend to go
to 0, which is why they are cheap in price and contain the maximum Risk of
loss. So, as an option buyer, you should avoid taking out-of-the-money options.
As an option seller, there are some risk management
rules you must take note of. For example, you should never trade without a stop
loss or a hedge. If you are an option seller, you contain an unlimited risk,
which is why it is important to understand the importance of stop loss. Option
seller makes a profit most of the time by selling out-of-the-money options, but
they can lose all that money plus more in a single trade if they do not get out
at the right time. So, as an option Seller, your win rate is more. On the other
hand, as an option buyer, your winning size should be more.
How Traders Can Eliminate Fear by Managing the Risk
Conquering the fear of losses is the most important
part of trading success. If you fear making losses, you will never learn new
things nor improve your trading .
We often say that fear has its roots in the unknown.
In the trading business, everything is uncertain. No one knows what will happen
in the next moment, so fear is natural when doing such a business. But
controlling that fear by keeping yourself calm in heated situations and
following the established process defines your profitability. By setting up the
stop loss, we can pre-define our losses and eventually eliminate the fear of
making huge losses. This is how you can control your fear of trading.
Risk Management is the most effective way to
control and even eliminate your fears. Generally, profitable traders are good
risk managers first. Almost all the great traders of the world have been great
at managing risks and that is how they became the top names in the field.
Despite doing your best to manage every Risk, there
are some risks in trading that cannot be avoided, such as a technical problem
at the exchange, for which, there’s no remedy at your end. Or there can be a
technical problem from the brokers’ end, in which case, if you have a backup
account with some other broker, then you can take counter positions; otherwise,
there isn’t much you can do about your plight.
The good news is that these incidents do not take
place very often, and even when they do, these situations are resolved rather
quickly.
Trading Psychology and Risk Management
Trading psychology and risk management are two
different concepts and practices that are closely related to each other. In
order to make a sustainable trading career, you need to master both of these.
Risk Management is nothing but strategy
development, and trading psychology is the execution of that strategy with 100%
efficiency. If you have a good risk management strategy but you are unable
to follow that strategy due to improper trading psychology, then that strategy
is worthless.
In order to improve your trading
psychology, you need to work on both your mind and body. Also, you need to
constantly go through the best trading books and other literature so as to
learn from others’ experiences. As a trader, your psychology is your weapon and
it plays a very important role in defining profitability. That is why more than
any trading strategy or technical analysis, it is your trading psychology that
matters.
There are many trading strategies available freely
over the internet, but you need to have the right trading mindset to make money
from that strategy. Often, amateur traders give more importance to their
strategy rather than their psychology, and that is the key reason why they fail
in trading at the initial stage.
Conclusion
Trading is serious business, and in order to make
money from it, you need to focus on the three most important aspects:
1)Trading
Psychology
2)Risk
Management in Trading
3)Technical
Analysis
You need to master all three in order to make
consistent profits in trading.
Risk management saves you from capital erosion. You
may have a good strategy but if you lack good risk management in trading, you
will inevitably end up with more losses than wins.
Before taking any trade, you need to check some risk
management criteria such as Risk per trade, the risk-to-reward ratio, position
sizing, etc., so that there is no confusion or fear after taking that trade.
Risk management eliminates the fear of trading by
predetermining losses. When you become fearless, you can perform with 100%
efficiency.
Trading psychology and risk management are closely
related, and you must master both aspects in order to become a profitable
trader. I hope that this article taught you the importance of risk management
in trading.
To summarize this article, I would
say with good risk management rules, some technical analysis, and risk
management principles; anyone can make a profitable trading system and earn
consistent profits from the market.
If you like this article, don’t forget to share it
with us across all your social media handles.
Happy learning!😟
Comments
Post a Comment