How to Identify and Manage Risks like a Professional Trader?

Possibly the most crucial component of stock trading, if you want to succeed as a retail trader, is risk management.

Many inexperienced traders do not pay enough attention to their risks. As a result, any good trades are outweighed by losses, resulting in blown trading accounts.

In this article, we will explain ways to manage risks. Before you take any trades, you must understand when to allocate risk and how much risk to allocate to specific trades.

Risk Per Trade

The majority of stock market trainers will advise traders not to risk more than 2 percent of their trading capital on any single trade. This is good advice that should form the foundation of your risk management strategy. If you’re a risk-averse trader, 1 percent or even 0.5 percent may be preferable. This is purely a matter of personal opinion, but more than 2–3 percent on any single trade is excessive.

Based on a Rs.1,00,000 trading account as an example. On a single trade, a 2% risk equals Rs.2,000 in actual monetary risk.

We observe a lot of inexperienced traders are disregarding this advice and risking 10 percent or more on a single trade. This will almost certainly result in a busted trading account. Of course, if you make a profitable trade using it, you’ll reap the profits.

Sector Rotation (Diversification)

You may have heard that good risk management requires diversity. As there are no guarantees in trading, this is true. Simply because one sector/industry is doing well does not mean you should put all your eggs in that basket.

Hence, one should look to diversify trades within various sectors/industries.

Overall Exposure (Position Sizing)

With swing/positional trading, everything moves more slowly and over a longer period. As your stop losses will be wider than in intraday trading, your actual position sizing will be smaller. Hence, your goal is to be in a trade for months at a time.

One must have an ideal risk exposure ranging from 7 percent to 10 percent of overall capital. This, too, is dependent on one’s risk appetite.

Example: For a Rs. 1,00,000 trading account, one can trade upto Rs. 7,000 –10,000 per trade.

Risk vs. Reward

The risk-to-reward ratio is a word that is frequently used in trading. One can trail a stop-loss behind the price until the trend has a significant reversal, at a point one can exit. This means that the prize could be unlimited. Profit can be accumulated for as long as the trend continues, which might be months or even years.

As a result, in a bullish trend, traders search for the best trade setups that have the least resistance ahead of them, and in a negative trend, they should look for the best trade setups that have the least support ahead of them. This reduces the chances of price reversing at the next barrier level.

When it comes to risk-to-reward, one should try to find low-risk trade setups. In a bullish trend, if the price breaks below a strong support level, one must tighten his/her stop loss and most likely exit the trade. Nothing will stop price from pulling back to one’s initial stop loss if there is no immediate support below the price.

Trade Log Maintenance

Keeping track of all of the above can be difficult. We recommend keeping track of all of your trades in a trade log or trade journal. This will not only allow you to reflect on and improve your trade, but it will also control your risk.

Position sizing, overall risk exposure, available trading capital, and reasons (psychology) to take trades must be documented in an excel spreadsheet. This allows traders to keep track of everything without having to manually assess risk across all trades.

Written by Aashutosh Chandra (aashutosh.chandra@xumitcapital.com)