How often have you come across the maxim that ‘Rome wasn’t built in a day but Hiroshima was destroyed in a day’? What does this actually mean and what has it got to do with trading? Stay tuned to get the answers to all your questions.
In trading, if you ask any professional trader, he/she is bound to tell you that those who make money in the market focus on the process and not on the outcome. How can you ensure that you are following the right process? It’s simple. You can do it by ensuring that you follow the right ‘Risk Management’ principles.
Risk management, in layman terms, is protecting your capital at all costs. Risk management has got a lot to do with being aware of the amount of risk you take, placing the right stop loss and understanding the potential return you can generate by taking any risk. For instance, if I risk $1,000 on a trade, in the worst scenario, my loss is only supposed to be limited at $1,000. This makes a good trader.
Let’s get this straight with a hypothetical comprehensive example:
- You want to buy shares of ABC @$100.
Before you execute the buy order on this trade, you must know your risk. Are you willing to risk a high amount or a low amount? What is high for you might be a petty amount for someone else. Hence, this is the first step of Risk Management, i.e, understanding your risk appetite.
- An ideal percentage would be limiting your risk to 2% of overall capital.
If you have $50,000 capital, 2% of it would be $1,000. Thus, now you know that in the worst case scenario, you cannot afford to lose more than $1,000 on this trade. This is the second important lesson of Risk Management, i.e, knowing your risk.
- Place your ‘Stop-Loss’
A stop-loss saves you from uncontrolled losses. It is an order which closes your position once the stock touches a certain price. In this trade, you are buying shares of ABC @$100. You see that there is a good support zone at $95. Hence, going by this analysis, your stop loss should be placed just below the support level @$94. A good risk management system is synonymous to placing the right stop-loss orders.
- Decide your ‘Position Size’ (number of shares to buy)
One of the major reasons why most retail traders fail to make it big in this market is because of improper position sizing. The number of shares you buy should be guided by proper risk management protocols. Your ideal position size should be the amount of risk divided by your stop loss in Rs. In this trade, we have risked Rs 1,000. We buy at $100. Our stop loss is placed at $94. The stop loss is of $6.
Position Size = Amount of Risk / Stop Loss $.
= 1,000 / 6 = 166 (approx)
Thus, the number of shares you buy will be 166 shares. In case the price drops by Rs 6, your stop loss will trigger and your loss will be limited to 166 X 6 = $996.
- Decide your ‘Profit Target’
If you have risked $1,000, you should make sure that your planned profit target meets the proper risk:reward criteria. A general rule of thumb in Risk and Reward is 1:2. Your reward should be twice your risk. My profit target for this trade will be $112. I buy @100, my stop loss is placed @94, and my profit target is @112.
- Execute your trade
Fine execution of trades is a skill which one needs to learn over time. It doesn’t come overnight but once you learn the skill of managing your trade with the right risk management lessons, success is certain.
In the given hypothetical example, let us look at the potential outcome which the trade can give us. The trade can end in one of the three possible following scenarios:
- Loss: Hits stop loss @94. My loss would be 166 x 6 = $996
- Profit: Hits profit target @112. My profit would be 166 x 12 = $ 1,992
- Break-even: No loss, no profit.
Whatever be the end-result, at the end of the day, you should be happy that you are on the path of being a successful trader because you have followed the right risk management lessons in your trading. Now you know, Hiroshima was destroyed in a day because they did not manage the risk. Don’t be the city of Hiroshima.
