The importance of risk management in trading cannot be over-emphasized .
The readers might find it difficult to believe but this one tool can increase your stock markets profit to exponential returns.
Don’t believe me .. read on.
Unlike its twin brother investing – which is more patient ,quite and calm, trading is a much agile and fast paced.
Therefore it requires a lot of discipline and practice to be a successful in trading.
While the rewards of investing are long term , trading can earn rewards in a shorter span of time , perhaps within weeks or months.
But trading has it own set of rules, which are very different from investing and any serious effort to earn from it demands strict discipline and rules to follow.
Lets look at the single most important aspect of trading and that is …. risk management.
If one can manage this single aspect, the result can be a phenomenal and can result in high double digit and even triple returns.
Risk management would comprise of two main aspects :
- Stop Loss
- Position sizing
First let’s understand the importance of losses and its impact.
Loss is an integral part of the trading journey and no trader can escape from losses even the experts. We cannot avoid losses but we can manage and control them.
The stock market with its very nature has a probability of success of 50%. So every time you take a trade there is 50% chance of a loss. We also understand that while the profits can grow several times the investment , the losses can result in the wipe out of the entire capital (at least theoretically).
So how do traders control their losses? By the clever usage of stop loss.
Stop loss is a mechanism by which a trader decides the maximum loss on a specific trade and if the price goes below that or in other words, the trade does not go as expected the position is exited.
Lets try to understand this further . If a trader makes 10 trades and losses 5% in first 5 trades and makes a profit of 10% in next 5 trades , the net profit attained will be Rs 20,788.
Whereas, if the losses on the losing trades were not controlled the net profit could have been lower.
| Trades | Principal | Loss /Profit |
| 1 | 100,000 | (5,000) |
| 2 | 95,000 | (5,000) |
| 3 | 90,000 | (5,000) |
| 4 | 85,000 | (5,000) |
| 5 | 80,000 | (5,000) |
| 6 | 75,000 | 7,500 |
| 7 | 82,500 | 8,250 |
| 8 | 90,750 | 9,075 |
| 9 | 99,825 | 9,983 |
| 10 | 109,808 | 10,981 |
| Total Return | 20,788 |
Now let’s take a second scenario wherein the loss on the first 2 trades has been increased to 20% and keeping all other trades the same, the result will be a loss.
| Trades | Principal | Loss /Profit |
| 1 | 100,000 | (20,000) |
| 2 | 80,000 | (16,000) |
| 3 | 64,000 | (3,200) |
| 4 | 60,800 | (3,040) |
| 5 | 57,760 | (2,888) |
| 6 | 54,872 | 5,487 |
| 7 | 60,359 | 6,036 |
| 8 | 66,395 | 6,640 |
| 9 | 73,035 | 7,303 |
| 10 | 80,338 | 8,034 |
| Total Return | (11,628) |
So, from the above it can be concluded that if we control our losses , the net returns on our trades will improve.
Now, let us understand with an example the usage of stop loss.
A trader decides to buy 100 shares of ABC Ltd at Rs 1,000 per share with the expectation that the prices are moving upwards from here.
So his total investment is Rs 1,00,000. However, being a smart trader he also manages his risk by putting a stop loss on his order, i.e. in the event that the prices do not rise as per the expectation the maximum loss on the order is restricted and controlled.
Therefore, the trader puts a stop loss on this order at Rs 950. So in case the prices move against the trader’s expectation the maximum loss that the trader will have is Rs 50 (per share) X (total number of shares) 100 = Rs 5,000
So in this way the trader by losing 5% protects the balance 95%. Because the loss which is 5% (at price 95) can fall further down and deplete the capital.
But if he is able to protect his capital , this 95% capital can be used in other trades to earn further profits.
There are a few ways to decide the stop loss for a trade. Some are based on absolute figures, for example 5% of capital, while others may be based on support and resistance of the price movements.
Now that we know the concept of stop loss, lets understand position sizing.
With the help of position sizing we determine the total investment in a trade, given the risk appetitive of the trader.
Lets understand with an example. The total available capital is Rs 1,00,000 and based on my risk appetite I am willing to take a risk of 5% or in other words I would be fine if I loose 5% of my capital. So 5% of Rs 1,00,000 is Rs 5,000/-
So now lets take our share of ABC ltd from the previous example.
Buy/Entry Price (A): Rs 1,000
Exit Price /Stop Loss Price (B) : Rs 950
Loss per share (C) = Rs 50
Maximum loss in amount (D) = Rs 5,000
No of units to be bought = D/C = 5000/50 = 100 units.
Therefore, in order to restrict the loss at Rs 5000, with per unit loss of Rs 50, the maximum units to be bought will be 100.
The selling price of the trade is determined as 2X/3x of the loss.
By using this system with discipline we can trade in a much more profitable way.
You can calculate the position for your trades through the position size calculator by clicking here.
Happy Trading.
