Risk Management Techniques for Active Traders

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Risk Management Techniques for Active Traders

Risk management aids in the reduction of losses. It may also assist to keep traders’ accounts from losing all of their funds. When traders lose money, they are exposed to risk. If the risk can be minimized, traders may increase their chances of earning money in the market.

It is a necessary but sometimes ignored condition for effective active trading. After all, without a strong risk management technique, a trader who has made significant gains might lose it all in only one or two disastrous deals. So, how can you create the greatest approaches for mitigating market risks?

This post will go through some easy tactics for protecting your trading winnings.

Key Takeaways

  • Trading may be interesting and even successful if you can remain focused, do your research, and keep your emotions in check.
  • Still, the greatest traders must employ risk management strategies to keep losses under control.
  • Staying in the game requires a planned and objective approach to trimming losses using stop orders, profit taking, and defensive puts.

Planning Your Trades

“Every fight is won before it is fought,” Chinese military leader Sun Tzu famously stated. This expression says that wars are won by preparation and strategy rather than combat. Similarly, skilled traders are fond of saying, “Plan the deal and trade the plan.” Planning ahead, just as in combat, may frequently spell the difference between success and defeat.

First, ensure that your broker is suitable for frequent trading. Customers who trade rarely are catered to by certain brokers. They have excessive commissions and do not provide the necessary analytical tools for aggressive traders.

Stop-loss (S/L) and take-profit (T/P) levels are two important strategies for traders to prepare ahead of time while trading. Successful traders understand what they are willing to spend and what they are willing to sell for. They may then compare the resultant returns to the likelihood of the stock meeting their objectives. They execute the deal if the adjusted return is high enough.

In contrast, failed traders sometimes initiate a transaction with no understanding of the points at which they would sell for a profit or a loss. Emotions begin to take control and drive deals for gamblers on a fortunate (or bad) run. Losses often cause individuals to cling on in the goal of recouping their losses, but winnings might motivate traders to keep on in the hope of making even more profits.

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Consider the One-Percent Rule

The one-percent rule is followed by many day traders. This rule of thumb basically states that you should never invest more than 1% of your money or trading account in a single deal. So, if you have $10,000 in your trading account, your maximum stake in any particular asset should be $100.

This method is popular among traders with accounts under $100,000; some even go as high as 2% if they can afford it. Many traders with larger account balances may choose for a lesser proportion. This is due to the fact that when the size of your account grows, so does the position. The easiest approach to limit your losses is to keep the rule around 2%—anything more and you’ll be losing a significant portion of your trading money.

Setting Stop-Loss and Take-Profit Points

A stop-loss point is the price at which a trader will sell a stock and incur a loss. This often occurs when a deal does not go as planned. The points are intended to avoid the “it will come back” mindset and to limit losses before they spiral out of control. For example, when a stock falls below a critical support level, traders often sell as quickly as feasible.

A take-profit point, on the other hand, is the price at which a trader will sell a stock and benefit from the transaction. When the extra upside is restricted by the hazards. For example, if a stock is reaching a crucial resistance level after a significant upward run, traders may wish to sell before a period of consolidation occurs.

How to More Effectively Set Stop-Loss Points

Technical analysis is often used to set stop-loss and take-profit levels, but fundamental analysis may also play an important part in timing. For example, if a trader is holding a company ahead of results, they may wish to sell before the news reaches the market if expectations have risen too high, regardless of whether the take-profit price has been met.

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Moving averages are the most often used method for determining these points since they are simple to compute and generally followed by the market. The 5-, 9-, 20-, 50-, 100-, and 200-day moving averages are important moving averages. These are best established by applying them to a stock’s chart and analyzing if the stock price has previously responded to them as a support or resistance level.

Support and resistance trend lines are another excellent spot to establish stop-loss or take-profit levels. Connecting past highs or lows that happened on considerable, above-average volume may be used to create these. The key, like with moving averages, is establishing the levels at which the price responds to trend lines and, of course, on large volume.

Here are some crucial factors while establishing these points:

  • For more volatile companies, use longer-term moving averages to limit the possibility that a meaningless price fluctuation would cause a stop-loss order to be triggered.
  • Adjust the moving averages to correspond to the intended price ranges. Longer targets, for example, should employ bigger moving averages to limit the amount of alerts created.
  • Stop losses should not be less than 1.5 times the current high-to-low range (volatility), since they are much too likely to be implemented arbitrarily.
  • Adjust the stop loss based on market volatility. If the stock price isn’t fluctuating too much, the stop-loss levels may be tightened.
  • As volatility and uncertainty grow, use established fundamental events like as earnings announcements as important time periods to enter or exit a trade.

Calculating Expected Return

Setting stop-loss and take-profit levels is also required in order to compute the projected return. The significance of this calculation cannot be emphasized, since it requires traders to think through and analyze their deals. It also allows users to compare multiple deals and choose just the most lucrative ones.

This can be calculated using the following formula:

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

This computation yields a predicted return for the active trader, who will then compare it to other chances to decide which stocks to trade. The chance of gain or loss may be determined using past breakouts and breakdowns from support or resistance levels, or by making an informed judgment for experienced traders.

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Diversify and Hedge

Making the most of your trading requires never placing all of your eggs in one basket. If you invest all of your money into one stock or one instrument, you’re asking for a large loss. Remember to diversify your assets across industries, market size, and geographic regions. This not only helps you control your risk, but it also offers up new options.

You may also find yourself in a situation where you need to hedge your bets. When the findings are due, consider a stock position. Consider adopting the opposing stance using options to assist secure your position. When trade activity has ceased, you may unwind the hedge.

Downside Put Options

If you are authorized for options trading, purchasing a downside put option, also known as a protective put, may be used as a hedge to limit losses from a losing transaction. A put option grants you the right, but not the responsibility, to sell the underlying stock at a certain price on or before the expiration date. As a result, if you hold XYZ stock at $100 and purchase the 6-month $80 put option for $1.00 in premium, you will be effectively shut out of any price decline below $79 ($80 strike less the $1 premium paid).

The Bottom Line

Before entering or exiting a deal, traders should always know when they intend to enter or quit. By using appropriate stop losses, a trader may reduce not just losses but also the number of times a transaction is terminated prematurely. Finally, organize your combat strategy ahead of time so you’ll know when you’ve won the fight.

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