Financial markets are no different from other kinds of markets as they are both subjected to risks as well as rewards. Interestingly, financial risks and financial rewards are very closely connected. And our success depends heavily on our ability to keep them apart.
Developing your risk management skills is one of the most crucial skills that you need to develop in order to become a successful trader. An effective trader is able to maximize his profit while reducing his risk to the absolute lowest possible level in order to achieve maximum profitability.
In this article, we will be discussing some of the common risk management techniques used in the stock market. As well as the ways in which you can utilize these techniques as you progress along your trading journey as you learn how to use them effectively.
1. Always Use Stop-loss and Take-Profit Orders
Regardless of whether you’re in the middle of a losing trade or a winning trade, you should make sure that you know when to stop. Stop-loss orders help you limit the potential loss, and take-profit orders help you make the profits you expect.
As you think Bitcoin will appreciate in value in the near future, you buy it at $30k. However, things don’t always go according to plan, especially when it comes to cryptos. You place a stop-loss order at $27k to minimize your loss if the market crashes. That’ll limit your risk to 10% by using a simple order.
Based on your analysis, you think the price will rise to $36k before falling again. Therefore, you decide to place a take-profit order at $36k to guarantee that your bitcoins sell at the desired price and you make 20%.
Most trading platforms let you set your stop-loss and take-profit the same way as when you buy something.
The risk/reward ratio can be calculated before you trade to make sure you are taking the right decision. You will be amazed at how much time and trouble you will save by doing so.
Using the Risk/Reward Ratio (R/R) in an investment is a useful tool for comparing the potential profit versus the potential loss of a trade. Here is an example of how it works:
In order to determine the take-profit, we have to calculate the difference between our stop-loss and the entry price. Since our stop-loss is 10% lower than our entry point, $36k is a good place to take profit, resulting in 20 percent profit.
The Risk/Reward ratio will be 10:20 or 1:2, which means we can double our investment by risking just half of it.
A position size basically means the amount of money you are willing to invest in one trade. If you want to use the 2% Rule here, simply don’t invest more than 2% of your investment capital in any one trade.
Let’s see how we can calculate the position size based on that rule:
Suppose you have a $50k account. Based on the 2% rule, you can’t risk more than $1000 in just one trade. In the previous example, the stop-loss was 10% below the entry point, which means each Bitcoin we buy could cost us $3k.
If we divide the 2% risk by the trading risk, we get the position size for this trade, which is 0.33 Bitcoin or $10K.
The two main emotions you might feel while trading are fear and greed. In a bull market, where prices are rising at a growing pace. You might feel compelled to invest more than your trading strategy suggests. Bear markets might make you panic sell your stocks without thinking about them.
To avoid irrational actions like this in the future, it’s vital that you stick to your trading strategy, which has been planned thoroughly beforehand based on your risk tolerance and market analysis, so as not to make any irrational decisions.
A diversification technique allows you to reduce your risk exposure by distributing your investment capital across different asset classes and markets, helping you avoid losing a lot of money on one asset.