Out of all my experience being an active trader in Financial Markets, I have learnt that the most important factor for long-term success and profitability in trading is ‘Risk Management‘. Even if you have written an Algorithmic Trading system with high accuracy, or you master stock selection using Fundamental Analysis, without Risk Management you can never succeed. Beginners often ignore this fact and blow up their account within few months. The intent of this article is to share some proven Risk Management strategies for Traders and Investors. If you follow these with discipline, you are definitely gonna be a profitable Trader in the long term.
Know where to Exit before you Enter
It is imperative to set your targets and stop-loss before you enter any trade. You show not blindly let you losses grow which can eventually wipe out your entire capital. There are specialized products for Day traders called ‘Cover Order‘ and ‘Bracket Orders‘ which allows you to set the Stop Loss and Target before entering the trade. Make the best use of these products in your trading strategies. Even if you are not a Day trader, put a definite Stop Loss order at the start of each Trading session for your positional holdings. This would save you from any Black Swan events. And never adjust your Stop Loss at any cost. The same theory applies for your Profit Targets too. If you are a Trend follower, slice your profits at different levels, For example, Book 50% profit at first target , 30% at second target and remaining 20% at third target. If you are trading on a Mean-Reversion strategy then it’s always better to book 100% profit at the first target itself, as you never know when a strong trend will start.
Risk Reward Ratio
Risk-Reward Ratio is one of the most important money management concept. Mathematically, it’s the ratio of Risk (Money that could be lost), and Reward (Target Profit) for any particular trade. For Ex: If you are willing to risk 1000 Rupees for a target profit of 2000 Rupees, then your risk reward ratio comes to 1:2. Before adopting any trading strategy, it’s necessary to gauge its risk reward ratio for a long term. Most of the modern trading platforms have risk-reward ratio in their back-testing report. Risk Reward ratio of 1:2 is considered good for any trading strategy, and anything less than that can vanish your capital in the long term. Check out the below link to calculate Risk-Reward ratio for your trading strategy:
Preserve your Trading Capital
It is wisely said that ‘If you learn how to preserve capital, you will definitely learn the ways to multiply it‘. You should be very careful while handling your trading capital. There should always be some surplus capital to compensate the phases of drawdown. For Ex: if you have 50000 capital and you decide to trade in Nifty Futures, which requires around 49000 margin at the time of writing this article. Now suppose your very first trade resulted in a loss of 10000. Then you would have 40000 left in your account and you would not be able to trade Nifty Futures anymore. Follow these 3 golden rules of capital preservation in Trading:
- Never invest more than 5% of your capital in a single trade.
- Diversify your capital into multiple instruments so that loss in one can be compensated through profit in the other.
- For Intraday traders Stoploss should not be more than 1% of your investment, while for Positional it should not be more than 5%.
Hedge your Investments
Hedging is a method to prevent your investments from unforeseen losses. It may not be required for Intraday trading, but is very useful for positional and long-term investments. Especially you should hedge your positions before any major economic events like Budget sessions, RBI meetings etc. Options are very useful instruments to hedge your position. For Ex:- You can sell a Call option or buy a Put option to hedge your Long position in Equity. In this case, even if your Equity position goes into loss, the Options will make some profit and the losses can be minimized. But always remember that you should not over-hedge.
Be Careful about Margin Trading
Margin Trading can be a boon for all retail traders if used judiciously. But it also has the potential of blowing off your entire account. Margin Trading is a concept which allows you to buy more securities than what you can buy with capital in hand. It’s like a loan from your broker or exchange. For ex: with a capital of 20000 Rupees you can buy securities worth 100000 Rupees. But the problem here is that 1% loss on 100000 Rupees is equal to 5% loss on the original capital. So you should always avoid excessive Margin Trading. Check out the below article to understand more about Margins.