Whatever business an entrepreneur becomes involved in, whether it’s research, or sales, or manufacturing, he will have risk. So do stock traders and investors.
Think about a shop keeper. He has the potential to have unsold produce left on his shelves. Perhaps employment laws change, impacting on the cost of staffing, or maybe his key staff up sticks and move on. He could encounter problems with suppliers, or electricity, or with his street being closed by municipal workmen for a period of time. There is a whole list of risks to his business of which he needs to be mindful.
To manage his risk, the shop keeper will take a number of actions. He will pay insurance premiums. He might hold special sales periods when he heavily discounts certain stock, and he will use the services of an accountant. He might have fostered close ties with a local temporary staff supplier, and could have a diesel powered generator for when electricity supplies get cut.
A good businessman will identify potential risk, thinking of the possible downsides to a business. He’ll calculate the effect and costs of adverse impact and take measures to protect himself against harmful events.
In your business and personal life you will also take precautions against risk. Life assurance, car insurance, income protection policies: they are all ways to manage your lifestyle risk. Perhaps you have protection against critical illness, and insurance against burglary or damage to your home because of flooding or fire.
You manage your risk across your life, and should afford your investments the same level of respect. Whether you trade actively or passively, by taking necessary risk management measures you will increase the performance of your portfolio and decrease potential losses.
Here are a few things to consider when managing the risk on your trading portfolio.
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Know your price levels
For the investors amongst you, this really is about price selection. It might be that you have selected your trade after conducting some pretty in-depth fundamental research. So you will have a good handle on the right price at which to buy stock. Give thought to what the right price to sell will be. Warren Buffet might have the funds to buy and hold forever, never mind market conditions, but us mere mortals have to be a little more nimble.
Knowing your buy and sell price before you enter a position will give more conviction to your stock trading. It will take the emotional play out of decision making.
The use of limit orders, particularly for active traders, will maximize these buying and selling opportunities. Technical traders – those that use charts and graphs to choose buy and sell levels – are likely to build these limit orders into a trading strategy.
Trading levels impact upon your profit taking strategy, and the levels at which you will place stop loss orders. A shop keeper will know the price at which he can buy his stock, and the price at which he wants to sell it before he places that order with the wholesaler. You should do the same with your investments.
Use a stop loss
So you want to make money, but how much are you prepared to lose?
One of the key rules of managing trading risk is limiting the potential downside should something untoward happen. You drive a car, and you insure against accident. You might insure third party, or collision, or comprehensive. What you choose depends upon the maximum loss you are prepared to take (as well as the cost, perhaps).
Using an appropriate stop loss on each stock position you hold will help remove that dreaded emotional tie to a trade, and ensure you enter each day knowing your maximum potential loss. No trader or investor has ever walked this planet without experiencing some losses. The winners are those that employ a good loss minimization policy, and stop loss orders are key to this.
On profitable positions, of course, you can move your stop loss limit accordingly to prevent the profit from disappearing should the market turn against you. Such a strategy is known as a trailing stop loss order.
Don’t go overboard on a position
You’ll have limited funds to commit to the market. Set a realistic profit target, and consider the potential loss. Remember that putting all your funds into one position will increase your potential risk (see Diversification, below).
If you use a stop loss strategy of, say 5%, but you are only willing to risk a maximum of 1% of your available funds on any single trade, then you need to calculate what your maximum trade size is.
Let’s say that you have $100,000 in your trading account, and you spot a real opportunity in stock ABC. Being a disciplined investor, you are only prepared to accept a loss of 1% of your funds on a single position. You calculate your maximum position size as follows:
((size of fund x maximum loss on position)/ stop loss) = (($100,000 x 1%)/5%) = $20,000
If you invest $20,000 in ABC, and the stop loss is triggered, then the loss will be limited to $1,000, or 1% of your fund.
If you are an active trader, using this sort of strategy means that you will need to make 100 consecutive losing trades to exhaust your funds. Using this type of position size management works extremely well with a diversification and stop loss order strategy.
Diversification and hedging
If you place all your funds in a single position, losing money becomes easy. Some positions win, and some lose. It’s the way of the markets. Even if you are investing in just one business sector, then spread that risk around several stocks. We’ve all heard of Enron and WorldCom: even the biggest companies can fall to zero overnight.
Of course, it’s better if you can become proficient with your analytical skills and knowledge across several business sectors: when one sector is retreating, another will be advancing. Diversifying a portfolio should be seen as opportunity creation just as much as risk management.
There will also be times when you might want to hedge a risk. Perhaps results are due, and your stock has been moving up in anticipation of a good set of numbers. If earnings are lower than expected, you can be sure the stock price will fall and your profits be harmed likewise.
When you go on holiday, you’ll take out holiday insurance to protect yourself against an unlikely event meaning cancelling your vacation. Give your stock opposition the same respect, and consider a hedging strategy. An options position taken to protect your profits through the results announcement can be unwound when the share price has stopped bouncing around.
Related: Truly Diversified Investments or Fourteen Similar Golf Clubs?
Cut your losses early, and let your profits build
You might employ a strategy that takes a profit when a target price is met. Or you might run that position hoping to build on the profit and use a trailing stop order to reduce the effects of a price reversal.
Cutting losses early, and running profits in a disciplined manner will help your investment and stock trading profits grow faster. Combining stop losses and trailing stop losses will increase your chances of maximizing investment return.
To make money, you have to bank the profits
Your investment profits are not profits until they are in your bank account. Don’t be afraid to take a profit, and leave a little for the next man. It’s very rare that an investor will buy at the absolute low and sell at the absolute high. Trying to do so could see your profits erode rapidly.
Too many investors buy a stock, see it rise strongly, and then begin to fall back. Then they hang on, believing that the price will recover to the point at which they could have sold a few days ago. They believe the stock is just pulling back before it will move forward again, stronger and higher than before. Then horror sets in when the stock price falls through the price at which the position was first bought. Horror sets in as a once profitable position turns to a loss.
Risk management includes having the ability to take a profit just as much as the discipline to limit a loss.
Related: How to Minimize Investment Risk
In conclusion
Picking the right stocks to buy is only part of the story of a successful investor. Managing risk, being disciplined in approach, and developing emotion free investment strategies will make you a better and more profitable investor, or trader, and help you to sleep easy at night.
Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.