Risk Awareness And Risk Management

The most important but often the most neglected part in a trade is risk awareness and risk management.Every trade involves a risk. You may have read a disclaimer on many sites “Trading foreign exchange /stock futures/options on margin carries a high level of risk and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange/stock futures/options you should carefully consider your investment objectives, level of experience and risk appetite.” This disclaimer is basically to make the trader aware that such instruments involve considerable amount of risk in terms of loss of capital and one must be aware of such risks while taking a trade and should learn methods of managing such risk.

Risk Awareness

Before entering a trade you need to be aware of the risks involved while taking a particular trade.Basically you should take note of the following:

1) Overtrading
If you are trading using leverage you need to be aware not to take a position which could lead to partial or complete loss of your trading capital in case the trade goes against you.Nowadays many online brokerages offering Forex,Contract For Difference(CFDs), Futures offer high leverage opportunities. Some offer a ratio as high as 1:400. This means if you put in $1000 u can take a position worth $400000. Now lets say you want to buy 50 CFDs of a S&P500 contract. The margin required for it will be just around 600$ approximately.Let us further assume that 1 point equals 1 dollar. So if the contract moves 10 points up you stand to gain 500$ (50contracts*10 points*1 dollar). At the same time if the trade goes against you , your account will stand reduced by 500$. So effectively although you can take such a huge bet you stand to either gain or lose upto 50% of your capital at one go!!!!! So you need to be aware of this aspect .

2) Wrong punching of Orders
Very often traders tend to put in their orders in a haste and instead of buying they may sell and instead of sell they may buy. This could prove expensive if your order size is large and the trade moves against you without your realisation.

3) Loss in connectivity
Since most traders use online platforms for their trading it is important to understand that your internet settings are reliable.Sometimes you may enter an order and a loss in connectivity may not allow you to close/modify the trade online.

4) Institutional Buy/Sell Risk
As a trader it is important to know that market is moved by the large traders and not the small speculators/retail traders. Large traders are typically Institutional traders who have large funds. You may take a trade which is with the trend but if there is an institution which thinks the opposite you may lose a sizable amount in the trade.

5) Uncertainty
By nature markets are uncertain. With so many diverse participants with diverse opinions market are bound to reflect some kind of ups and downs

Risk Management

This is the most important aspect in trading and goes a long way into differentiating between a successful trader and an unsuccessful one. A trader may have 10 wins but if he does not manage his trade efficiently he could lose all the gains and much more in one single trade which is bound to go against him at some point in time.

Risk can be managed in the following ways:

1) Maintaining a Stop Loss(SL)
Before you enter a trade the exit strategy needs to be pre determined. You must know before hand how much you are ready to risk on a trade. Stop loss means that price at which you are ready to take losses and quit the trade in case the trade goes against you. Stop loss may be an amount or it could be a percentage of the buy/sell price. For eg. You decide to buy 10 Apple shares @ $250. So you initial investment is $2500. On this trade you are willing to risk say 5%. So your stop loss would be $250*5%= $12.5. So the price at which you would exit if the trade would go against you is $237.5($250-$12.5). This enables you to protect your capital in case the trade goes against you.
You should also protect profits by maintaining a trailing SL. For eg say Apple moves up to $280. The trade has now moved in your favour. You can not update your SL at $265 thereby locking in $15 profit.

2) Position Sizing
This means how much shares/contracts you are willing to buy after knowing the amount you are ready to risk. Let’s say you have a capital of $10000. Apple shares trade at $250. Based on your study of technical analysis you come to a conclusion that the SL is a little lower at $230. But the stock is in a nice upswing and can go to $300.If you base it on a percentage of 5% your SL is at $237.5 but you could be stopped out much earlier.But you want to remain in the trade without being stopped out early.So instead of basing the SL on a percentage you can reduce the number of shares by keeping the stop loss at $230 and working out the amount you can afford to lose on the trade in case it goes against you. So say you are willing to risk $400 on the trade. Accordingly you can buy 20 shares of Apple. The differentiation here is that if the SL would have been at $237.5 you would be risking less i.e $250 if you bought the same number of shares or you could buy more number of shares by risking $400 but the probability of being stopped out would be higher since the SL was too low.

3) Proper infrastructure
It is imperative to have reliable internet connectivity or alternatively you should be able to phone your broker and make trades offline.

4) Use Limit Orders
Always use limit orders while placing trades with entry,SL and if possible targets. Also check your orders before you press the button.

5) Advanced strategies
Besides this one can follow advanced strategies like covered call, cover puts which could protect your portfolio from erosion.

One thing that is imperative to understand is that there is no HOLY GRAIL in trading. Traders follow various methods of trading ; eventually it is those ,who are aware of risks and are able to manage those risks efficiently, who eventually become successful in this tough game.

Happy Trading!!!!!!

Savio

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