Effective risk management is essential for preserving a trader’s account and minimizing losses. The most successful stock traders use a combination of several risk-management strategies to avoid leaving themselves vulnerable to market downturns and losses.
What are the best risk-management strategies to employ to protect your investments? Here we explain three risk-management strategies employed by professional stock traders.
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Establishing a stop-loss and take-profit point
Before embarking on any project in business, government, education, or the public sector, the first thing everyone does is define their terms of success. If you don’t have clear terms of what success looks like and what failure looks like, how will you know if you have been successful?
In trading, success and failure is defined by stop-loss (S/L) and take-profit (T/P) points. These are the points at which the trader would sell the stock, either at a profit if the price increases, or at a loss, if the price falls.
These points should be set before purchasing based on the probability that a company’s share price will reach a certain point. This also helps take emotion out of trading. It avoids the temptation to keep a stock after its price has increased beyond a certain point in the hope it will continue to do so. It also prevents emotion causing you to hold onto a falling stock in the hope that it bounces back.
The One Per Cent Rule
Many traders subscribe to the one per cent rule. This dictates that you never risk more than on per cent of your account value on a single trade. If you have $30,000 in your account, you can only buy $300 worth of stock on a single trade, or one per cent of the total value.
This rule is designed to protect your account balance. Even if you are the unluckiest investor on the planet, you would need 100 poor investments in a row to wipe out your balance.
Many day traders will set their T/P at 1.5 per cent or 2 per cent and build up their profits by making many trades and securing small profits on each one. This is a far safer strategy than risking 10 per cent of your balance in a single trade and hoping for significant returns on a single stock.
There are times when investors will hedge their investments to minimize risk. Consider a scenario where you have shares in a popular tequila brand. You have faith that the brand will continue its upwards price trajectory in the long term. However, in the short term, there are several indicators that the price of agave is set to rise, which could impact the tequila brand’s share price.
To protect your investment, you decide to take out a futures contract on a prominent agave manufacturing company. This will automatically buy stock in the company if the price reaches a pre-determined level.
This means that if the price does increase, the investor’s losses will be offset by the investment made into the agave manufacturer. If it doesn’t, the price will not have been met and stock will not have been bought.