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A Guide on How to Manage Risks while Trading Stocks

A Guide on How to Manage Risks while Trading Stocks
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To manage stock market trading risk and create a trading plan, follow these steps:

PART 1: A Trader’s Typical Profit & Loss Account

Trading is a 50:50 proposition. A 60% win ratio in the market is considered as a terrific achievement.

Successful traders make money because:

(a) Targets are higher than SLs. For example, 2% target and 0.75% SL with a 50% success ration works out to a 62.5% gain (50 X 2% = 100% (minus) 50 X 0.75% = 37.5%)

(b) They are extremely disciplined

(c ) They are not emotional about their trades, and follow their trading plan/risk management policy

PART 2: Determine Your Trading Capital

(a) Fix your trading capital. Remember that 80% to 90% of total investible funds are typically deployed in long term investments, and the rest are allocated to trading

(b) Take into account whether your trading capital is fixed or floating. That is, many traders (salaried, businessmen) add to it every month and it keeps increasing.

Fix a monthly number. Perhaps you can make an Excel sheet that contains a column for monthly trading capital allocation.

PART 3: How much can you afford t0 lose per trade?

The first question to ask yourself after fixing your trading capital is —

How much can you afford to lose per trade without upsetting you psychologically or financially? This is the key to your trading success.

Let’s take an example:

(a) Trading Capital = Rs 1,00,000
You want to deploy it in = 20 Trades
Therefore maximum loss/trade that you can take is = Rs 5000

(b) Now with Rs 5,000 fixed as a Stop Loss number, you need to check your investment strategy. Should you invest in Futures, Options or Spot?

(c) You cannot invest in Futures because the margin per lot is upwards of Rs 1,00,000, and that is higher than your trading capital. So, Futures is out.

(d) You can invest in options, but know that options lot quantities are rather large and a small fluctuation in the CMP can trigger your stop loss. For example, IGL lot size is 2750, and therefore if you buy one lot, a small movement as low as Rs 1.75 in the CMP can trigger your SL. Therefore, if you cannot take a loss of more than your budgeted number of Rs 5,000, then options are not for you. Perhaps, in options, you can consider investing in stocks in which the lot size is small (for example, RIL, Page Industries, Bajaj Auto, etc.)

(e) The safest trade in this example would be to invest in the spot market.

(f) I’m not even considering writing options because that is extremely risky and not for the average retail trader.

This chart will give you an idea on how risk can be managed per the numbers given in the example above:

how to manage trading risk

PART 4: Fine Tune Your Trading Psychology

First off, know that in a series of 10 trades, the following are the worst and the best case scenarios:

managing risks in stock market

In the first scenario, a trader tends to become depressed and he will likely stop trading because he feels he cannot make money.

In the second scenario, a trader tends to become overconfident and he will likely start stepping out of his trading plan and become indisciplined.

If you have to survive in the market, you must follow your trading plan. If you don’t, you will ultimately lose money.

That said, you also have to fine tune your trading psychology. Here is a list of Do’s and Don’t’s:

DON’T

1.Work with greed and fear. Use logic. Set modest targets and stop losses.

2.Trust your eyes based on what you see on the charts alone. (Also analyze FnO Data).

3.Forget that trading is a 50% proposition.

4.Grieve losses, or celebrate gains – just move on.

DO

1.Stick to your risk management plan.

2.Analyze the short term trade trend before entering into a trade.

3.Trade per your capital and risk management policy. Choose an instrument wisely (Cash, options, futures)

4.Be prepared one day in advance (by evening before trading day)

5.Be extremely disciplined

So that’s it. A Trading Plan and a Risk Management Policy is actually common sense, but many traders do not follow it. Start with these simple trading and psychology tune-ups and you will see the results in a couple of months when you become a disciplined trader and from then on you can start your journey to go pro. Good luck.

1 Comment on "A Guide on How to Manage Risks while Trading Stocks"

  1. very true article…thanks

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