The secret Mantra in the world of Trading is, “Try and Increase the controllable and reduce the uncontrollable”
The above quote might sound absurd at first instance but if we were to think about it, it would make a lot of sense. If we have a proper understanding of the market, have a set rules for the trade, and most importantly proper Risk Management in trading then, it would go a long way in increasing the factors which we can control and increase our probability of generating substantial returns.
Now, through this write-up, we will try and understand the Risk Management Aspect of Trading.
What is Risk Management?
To put it in simple words, Risk management in the context of trading is the process of identifying, managing and controlling the risk associated with any trade. To be able to manage the risk effectively would simply mean that one is able to control as much as possible the future outcomes of the event.
We might not be able to completely nullify the risk associated with the trade but, we might be able to minimize the impact of it.
Risk Management Assessment and Strategies
Following are some of the factors that help us in Assessing the risk while trading:
- To understand the Context: Understand the current trade setup and what scenarios are leading to the trade in question. And if we are able to do this then we will be able to understand the risk which comes with the trade
- Risk Scenarios: After the trade has been identified, it becomes important for us to understand the circumstance under which the trade could go wrong and the risk which is attached with it.
- Risk Identification: This simply implies the various factors which bring in the risk which is associated with the market and how does it impact the world of trading. The factors could be changed interest rates, the central government taking some steps which have an impact on the market or could be a simple trade war.
Before making a trade decision, all these factors need to be assessed. And, if we are well prepared to handle these scenarios, we will be better prepared to trade various products like derivatives, diversifying the risk etc.
Importance of Risk Management in Trading
The most important thing in Trading is, “PLAN YOUR TRADE AND TRADE YOUR PLAN”
- Proper Risk Management applies both to Investing and Trading, but it becomes of paramount importance if you are a trader. An investor has time on his side as he is able to wait patiently for the market to move in his direction. But if you are a trader, then you would ideally want the trade to move in your favour as soon as possible. And if it doesn’t, risk management comes into the picture.
- If you are a trader in the derivatives market, risk management is the most crucial skill that one must possess. Options as a derivative instrument are very risky by nature because there are various factors that become a part of it and the most important amongst is ‘Time’. As and when we move closer to expiry, the premium value decays and we might not make any money even though our view could be right.
Say, I have a bullish view on the share price of Reliance Industries. The current price of one share of Reliance Industries is Rs. 2200 (say) and I am of the view that the share price should still be having upside potential and to express my view, I buy 2300 strike price Call option of Reliance industries by paying a premium of Rs 30.
With still 10 days left to expiry, there is a decent potential of trade expiring In the Money for me. But by expiry, the share price of Reliance Industries goes upto to Rs. 2290 only. So, although my view of bullishness is right on the market, but the trade has still resulted in a loss. And this is where risk management becomes more important if we are trading derivatives.
- The most important tool for proper risk management is the usage of Stop loss. This tool is the most talked about, but yet the most underutilised one. Putting stop loss not only minimises the loss which one could incur but, also spares time to look out for other opportunities. And using Trailing Stop loss is the best way to protect money if the trade is already In the Money.
- And lastly, the most important thing that any trader or investor needs to keep in mind is that once the trade is In the Money, the role of target and Stop loss becomes very important. Always keep Trailing your stop loss and don’t be very stubborn about your profit targets. If the market is finding stiff resistance before your actual target, there is no harm in booking your profits and wait for the next trading opportunity. Remember, “Profit in hand, is better than Profit in books”
Risk Management is the most important skill which any trader must possess. It is more important than having the art of spotting the trades. A missed trade opportunity is much better than having taken a trade and poor risk management in it.
So, it is advised to all the new experienced traders in the market, for a long and profitable trading career one must master the art of managing the trade and most importantly managing your trading capital.
Happy Trading and Money Making!!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!