Risk management is one of the most important aspects of stock market investing and yet the most overlooked aspect.
In fact, if this single aspect is well understood stock market trading can be almost risk free.
Yet most of us will be running after trading systems indicator tips and what not.
So lets understand how with the use of risk management not only can we save our capital but also multiply our returns many fold by following these simple techniques.
One of the favourable aspect or stock market is its liquidity aspect wherein we can liquidate our investment and convert it into cash on a click of a Mouse and have our cash with us within no time.
This one aspects makes the stock market very dynamic system wherein we have the opportunity to correct our mistakes with minimal cost.
Cash is the most important but scarce resource. So we need to protect preserve and grow this scarce resource all the time. But when we are trading in the stock market a lot of times our calls go wrong which could result in losing our most important resource – cash.
So our goal should be to minimise this risk at all times. If we have sufficient cash on hand we will find ample of opportunities in the market to earn and recover our loss. But if we loose our cash , we will not be able to recover our losses and earn as we have limited capital.
Lets understand this mathematically.
Suppose I enter in a trade with Rs, 100,000 but my call goes wrong and I incur a loss in my position of 5% i.e. Rs, 5,000 . But I still hold the stock expecting it to reverse, the loss now increases to 9% i.e. Rs, 9000.
I still hope that it will reverse from the next support level and i will be able to recover my loses and will be able to sell it on atleast break even.
With this expectation I hold to my position but the stock does not hold the expected support levels and my loss now increases to 25% i.e. Rs, 25000/-
Now I am unable to sell my position because my loss is 25% and i think that it will be a huge loss on my position and I once again hope that it will reverse in a few weeks and months and then may be my loss will around 10% and then I can sell at a lesser loss.
But unfortunately , my hope is not fulfilled and the stock falls further to 45% of my capital i.e. Rs, 45,000.
The stock falls a further and now I have lost all hope of its recovery and I sell it at a loss of Rs 50,000 to salvage whatever I can and curse the stock market that it is a risky place and that it is a gambling den.
This is the typical mindset that most of the retail investors have when they trade in the stock market.
Now lets analyse where we went wrong.
If we would have exited when we were at a loss of 5% i.e. Rs 5,000 then to recover our loss of 5% we would need a profit of 5.27% in our next trade.
Similarly if we would have exited at 9% loss in order to recover our lost capital we would need 9.89% profit in our next trade.
So if we analyze the below table we notice that the higher the loss, the higher return on remaining capital will be required to recover our lost capital.
Initial Capital | Loss % | Loss Amt | Capital after Loss | Reqd return to recover loss | Return in Amt |
100,000 | 5% | 5,000 | 95,000 | 5.27% | 5,002 |
100,000 | 9% | 9,000 | 91,000 | 9.89% | 9,000 |
100,000 | 25% | 25,000 | 75,000 | 33.34% | 25,005 |
100,000 | 45% | 45,000 | 55,000 | 81.82% | 45,001 |
100,000 | 10% | 10,000 | 90,000 | 11.12% | 10,008 |
100,000 | 15% | 15,000 | 85,000 | 17.70% | 15,045 |
100,000 | 20% | 20,000 | 80,000 | 25.00% | 20,000 |
100,000 | 30% | 30,000 | 70,000 | 43.00% | 30,100 |
100,000 | 50% | 50,000 | 50,000 | 100.00% | 50,000 |
So therefore , we can conclude that the sooner we cut our losses the easier it is recover our lost capital.
The generally accepted sweet spot is a loss of less than 10%, any loss above this makes it difficult to recover our losses.
So now that we are clear about the loss size how do we calculate the optimum size and structure our position.
For this first we have to decide the maximum acceptable loss per trade. This is a percentage of our total capital used for trading and it should not be more than 2%.
So for eg if I have a capital of Rs 1 Lakh the maximum amount I am ready to loose per trade is 1% of 1 Lakh which is Rs, 1000/-
Now I decide my entry price and stop loss price based on the chart patterns and price movements. The max total acceptable loss when divided by the loss per unit gives total no of stocks to be bought at the given parameters.
As for the exit from the position it has to be done in R multiples i.e. if I take a risk of R% percent my return should be min 2R.
For a ready calculator to make these calculations click here.
If you follow this method your risk in the stock market is almost nil, if you ignore this, your trading will be like the rest of 99% traders, i.e. non-profitable.
Choose for yourself.
Good luck!
