Within the stock market’s rapid environment, traders naturally gravitate to a focus on the potential rewards and are actively searching for the next several hundred percent “score.” Simply consider this - The only difference between a successful trader over a long term, and a speculative trader over a short term, is the simplest of disciplines: Risk Management. Risk Management is more than a method. To be a serious trader facing the reality of managing trading risk for the protection of capital, it is a mindset.
In this risk management guide, we will provide an overview of some basic risk management principles and related strategies, tactics, or actions to limit losses and increase the probability of consistent profits.
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What is Risk Management in Trading?
Risk Management in Stock Trading, at its most basic definition, is the analysis, evaluation, and management of the risk associated with your trading or investing to help protect your capital.
It is also worth pointing out that there is risk-taking place with trading or investing. The point of sound trading risk management is not to eliminate losses - that is impossible - but to ensure the losses are as small as is reasonable and possible, manageable, and not put your ability to continue trading at risk. Professionals manage risk first, and profits will come with discipline.
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Types of Risk in Trading
To help manage risk, you should first understand the different types of risks for your capital.
A. Market Risk (Systematic Risk)
Market risk is the risk that affects the entire stock market or a large part of it. Market risk cannot be diversified away. Examples are recessions, interest rate hikes, and geopolitical risks. This is why, in a major incident or crisis, you see the majority of all stocks drop.
B. Unsystematic Risk (Specific Risk)
An example of unsystematic risk occurs when there is risk due to a specific company's risks or that of the entire industry. For example, a recall of its product, a management scandal, or the failure of its technology that resulted in a decrease in a single stock. Unsystematic risk can be somewhat reduced through diversification.
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C. Liquidity Risk
Liquidity risk occurs when you cannot buy or sell your asset quickly enough without substantially affecting the price. The concern about this typically occurs when you are buying or selling a low-volume stock.
D. Leverage Risk
If you engage in derivatives or use margin (borrowed money), your potential returns will be greatly expanded, but you magnify your losses massively. Learning how to effectively use leverage in the stock market for beginners means learning how to understand and manage this risk and risk which is magnified as you are using borrowed margin.
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Risk Management Strategies & Tools
These are the fundamental guidelines for effective risk management. Understanding these components has relevance when developing a positive risk strategy in the stock market. If you're interested in a deeper analysis of A, consider our Technical Analysis Crash Course and Fundamental Analysis Crash Course.
I. The 1% Rule: Position Sizing
Determining the proper position sizing is the most critical aspect of trading risk management. The 1% rule states you should never risk more than 1% to 2% of your total trading capital in a single trade.
Example: If your trading capital account has $20,000, your maximum loss on any one trade should be $200 (1% of $20,000).
Actionable Strategy: This provides a maximum loss per trade, so no single bad trade can damage your account.
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II. Stop-Loss Orders (S/L)
A Stop-Loss Order is an automated order you place with your broker to sell a security at a given price. It is your actual insurance policy.
Function: After you know what your risk is for each trade (per the 1% rule), you set your stop-loss price to protect your risk at the maximum price that you predetermined.
Further Reading: To understand placing orders, please see our blog on Top Technical Analysis Tools.
III. Understanding the Risk-Reward Ratio (RRR)
Before taking any trade, you need to determine the potential profit (Reward) against the highest loss you may experience (Risk). This is called the Risk-Reward Ratio.
Recommended Practice: Successful traders want a 2:1 or 3:1 RRR, which means you are looking to earn $2 or $3 for every $1 you risk.
The Importance of the RRR: If you have a 2:1 RRR, you could lose 66% of your trades and still break even. You will stay consistent and will continue to build your account balance over time, even with a small winning percentage.
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IV. Diversification
Do not risk your entire capital on one stock or one sector of the market. A strong risk management strategy is called diversification, and it means spreading your capital out by putting it into different assets, sectors, or even markets to help limit your exposure to unsystematic risk.
Suggested Read: If you are interested in understanding broader market themes, please read our post on Equity Market Basics.
Developing Your Personal Risk Management Plan
Risk management is not something you want to react to; if you need to react, you have already lost. You need a written risk management plan for all outcomes to manage trading risk.
What is Your Risk Tolerance: Be brutally honest with yourself about how much money you will psychologically be comfortable losing. This will determine your risk limits per trade.
Create Clear Rules for Trading: For every trade, you should have a clearly defined entry price, stop-loss price, and profit target (take-profit orders) set up before you enter the trade.
Establish Daily/Weekly Loss Limits: You should decide on a maximum percentage of your total capital that you are willing to lose in a day or timeframe. If you reach that limit, stop trading immediately and take a break. Understanding the elements of your mental game, while working to keep it in control, is crucial; take a look at our course on Emotion Controlling in the Stock Market.
Evaluate and Enhance: Use a trading journal to note your adherence to your own risk management plan. Use your journal to examine your losing trades – did you violate your own rules?
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Conclusion
The reason for learning stock is straightforward: Pros concentrate on the risk, Amateurs concentrate on the return.
Risk Management is the fundamental skill that sustains your business and profitability. When you consistently and effectively apply the 1% Rule, use Stop-Loss Orders religiously, and properly calculate a favourable Risk-Reward Ratio, you flip the switch from playing slots or blackjack to an engaged profession.
The most significant distinction in your trading profits is not how much you made on a winning trade, but how little you lost on a losing trade; build your shield today.
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