Importance of Risk Management in trade
The primary goal to invest/trade in the stock markets is to make money. However, we will never achieve this goal if we do not know why and how to manage risk. Expert Traders are nothing but Risk Management experts.
Why risk management has top priority
In trading, risk management is far more important than anything else. To make money, we need a trading stake. How could we make money if our trading accounts are wiped out or our capital is tied in some rotting positions? It is absolutely OK to have losers. But it is NOT OK to hold onto them once Mr. Market has warned us to get out. Here is a post about how to set stop loss orders.
How to control your risk
So the first thing is to cut the losers. Nevertheless. It is not enough to just cut the losers. If we have too many losers to cut in a very short period time, they add up. We will have to set our overall loss cap and adjust our position size accordingly. For day trading, our loss per trade should not exceed 0.5% of our total capital and our daily loss cap should be no more than 1.5% of our trading capital. In other words, we stop trading after 3 losers in a row. A daily loss cap is not enough; we need to set a weekly cap too. My weekly cap is 5%. If I have lost 5% by Wednesday, I will stop trading for the rest of the week. And my monthly cap is 10%. These values can differ from trader to trader. It is like salt in your food. Necessary but vary as per taste.
We will also have to pay attention to our position size also. Position size should be reduced to a level where we can feel comfortable without looking at it and thinking about it. If we are constantly worried about our positions, then they are too big and our judgment will be impaired.
In order to control position size, we will have to pay attention to what sectors our positions are in. If we have SBIN and UBI at the same time, then they are considered one position since they move together. We should only have one of them or at least split our allotted capital between them. For example, after careful studies, you feel comfortable with 10,000 per trade. You normally choose whatever is the strongest in a sector. Let’s say SBIN. You put 10,000 into SBIN and have nothing in UBI. If you really like UBI, then do a 50/50 or 60/40 split between SBIN and UBI. You just can not have 10,0000 in each since that would be equivalent to 20,000 in a banking stock.
Another good thing about reducing the size of our positions is that we could use a wider stop loss and still not exceed our risk threshold. If our risk for each trade is 200, then our stop loss would be 2% of a 10K position or 4% of a 5k position. With the same amount of risk, a wider stop loss works better than a narrow one. Of course, our profits will drop due to the reduced size. But once again, I will put risk control before anything else in trading.
Here is the recap
- Cut losers
- Set a daily/weekly/monthly loss cap
- Control position size
- Pay attention to sectors