Risk Management Techniques for Active Traders

Risk Management Techniques for Active Traders

Risk management helps reduce losses. It can also help protect traders' accounts from losing all their money.

Risk occurs when traders suffer losses. If risk can be managed, traders can open up to make money in the market.

It is an essential but often overlooked prerequisite for successful active negotiation. After all, a trader who has generated substantial profits can lose everything in just one or two bad trades, without a proper risk management strategy. So how do you develop the best techniques to contain the risks of market?

This article will discuss some simple strategies that can be used to protect your trading profits.

Key Advantages of Risk Management

  • Trading can be exciting and even profitable if you are able to stay focused, do your due diligence, and keep your emotions in check.
  • Still, the best traders need to incorporate risk management practices to keep losses from getting out of hand.
  • Taking a strategic and objective approach to cutting losses through stop-loss (S/L) and take-profit (T/P) is a smart way to stay in the game.

Planning Your Negotiations

As the famous Chinese military general Sun Tzu said: "Each battle is won before it is fought." This phrase implies that planning and strategy—not battles—win wars.

Likewise, successful traders often quote the phrase: "Plan the trade and trade to plan." As in war, planning ahead can often mean the difference between success and failure.

First, make sure your broker is suitable for frequent trades.

Some brokers serve clients who trade infrequently. They charge high commissions and don't offer the right analytical tools for active traders.

Stop-loss (S/L) and take-profit (T/P) points represent two main ways traders can plan ahead of time. negotiate.

Successful traders know what price they are willing to pay and at what price they are willing to sell.

They can then measure the resulting returns against the probability that the stock will meet its objectives. If the adjusted return is high enough, they execute the trade.

On the other hand, unsuccessful traders often enter a trade without having any idea where they will sell at a profit or loss.

Like lucky — or unlucky — players, the emotions begin to dominate and dictate their negotiations. Losses often lead people to wait and hope to get their money back, while profits can lead traders to recklessly hold back for even more gains.

Risk Management: Consider the 1% Rule

Many day traders follow what is called the one percent rule. Basically, this rule suggests that you should never put more than 1% of your capital or your trading account into a single trade.

Therefore, if you have $10.000 in your trading account, your position in any instrument should not exceed $100.

This strategy is common for traders who have accounts of less than $100.000 — some even go as high as 2% if they can pay.

Many traders whose accounts have higher balances may opt for a lower percentage.

That's because, as your account size increases, so does your position. The best way to control your losses is to keep the rule below 2% — anything more and you are risking a substantial amount of your trading account.

Defining Stop-Loss and Take-Profit Points

A stop-loss point is the price at which a trader will sell a stock and lose in the trade.

This usually happens when a trade doesn't go the way the trader expected. Points are designed to avoid the “it'll come back” mentality and limit losses before they escalate.

For example, if a stock breaks below a key support level, traders usually sell as quickly as possible.

On the other hand, a profit-taking point is the price at which a trader will sell a stock and make a profit on the trade. That's when the added benefit is limited, given the risks.

For example, if a stock is approaching a key resistance level after a big bullish move, traders may want to sell before a period of consolidation occurs.

How to Set Stop Loss Points Effectively

Defining stop-loss and take-profit points is usually done through technical analysis, but fundamental analysis can also play an important role in timing.

For example, if a trader is holding a stock ahead of earnings as enthusiasm builds, he may want to sell before the news hits the market if expectations become too high, regardless of whether the profit-taking price has been reached. .

Moving averages represent the most popular way to define these points as they are easy to calculate and widely tracked by the market.

The top moving averages include the 5, 9, 20, 50, 100 and 200 daily averages. These are best defined by applying them to a stock's chart and determining whether the stock's price has reacted to them in the past as a support or resistance level.

Another great way to place stop-loss or take-profit levels is on the support or resistance trendlines.

They can be drawn by connecting previous highs or lows that occurred at a significant volume above the average. As with moving averages, the key is to determine the levels at which the price reacts to trend lines and, of course, high volume.

When defining these points, here are some important considerations:

  • Use longer-term moving averages for more volatile stocks to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
  • Adjust moving averages to match target price ranges. For example, longer targets should use larger moving averages to reduce the number of signals generated.
  • Stoploss should not be closer than 1,5 times the current high to low range (volatility) as they are very likely to be executed for no reason.
  • Adjust stop-loss according to market volatility. If the stock price is not moving much, stop-loss points can be reduced.
  • Use known fundamental events such as earnings releases as key periods for entering or exiting a trade as volatility and uncertainty can increase.

Calculating Expected Return

Setting stop-loss and take-profit points are also needed to calculate the expected return.

The importance of this calculation cannot be overstated as it forces traders to think about their trades and rationalize them. In addition, it offers a systematic way to compare multiple trades and select only the most profitable ones.

This can be calculated using the following formula:

[(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)]

The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade.

The probability of gain or loss can be calculated using historical breakouts and breakouts of support or resistance levels — or for experienced traders, making a well-founded estimate.

Put Downide Options

If you are approved for options trading, buying a negative put option, sometimes known as a protective put option, can also be used as a hedge to avoid losses in a trade that goes bad.

A put option gives you the right, but not the obligation, to sell the underlying shares at a specified price at or before the option's expiration date.

Therefore, if you own XYZ shares starting at $100 and buy the $80 put option for $1,00 per option in premium, then you will be effectively barred from any price drop below $79 ( $80 strike minus the $1 premium paid).

Diversify and Protect

Ensuring you get the most out of your trading means never putting your eggs in one basket.

If you put all your money into one stock or instrument, you're setting yourself up for a big loss.

So remember to diversify your investments—both in industry sector and market capitalization and geographic region.

This not only helps you manage your risks, it also opens you up to more opportunities.

You may also find a time when you need to protect your position. Consider a position of an action when results are anticipated.

You might consider taking the opposite position through options, which can help protect your position. When trading activity slows, you can undo the hedge.

Risk Management: Conclusion

Traders should always know when they plan to enter or exit a trade before executing it. By using stop loss effectively, a trader can minimize not only losses but also the number of times a trade is needlessly closed.

In conclusion, make your battle plan ahead of time so you already know you've won the war.

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