Risk Management - Stock Market

Many people overlook the importance of managing risk in their positions and trades. As a trader or investor, this is the only thing that we can control. We cannot control the directions of the markets. We also cannot control whether we will win or lose in any position we take. The only thing within our control is the amount of loss we will suffer.

To most traders, risk management means simply setting stops. Many investors do not even do this to control risk. However, there is much more to managing your risk in the markets. You wouldn't drive onto a bridge if you have noticed that most of the supports have crumbled would you? Would you walk onto a frozen lake after seeing a "Thin Ice" sign posted and several cracks showing in the ice itself? Of course you wouldn't, that is because you observed the environment and realized that it was too risky to proceed.

We need to observe the same discipline when we are involved in the financial markets. To analyze risk before trading or investing, we must look at the current market environment, the security's environment and the trend. Are we in a danger spot that would preclude us from taking a trade? Suppose the markets were bearish, your security has just released disappointing earnings and is near supply on your trading time frame. Would you buy shares just because prices moved up slightly? Most likely you wouldn't. Even though you have a short term bullish move, the overwhelming bearishness of the markets tells you that the environment is risky and the reward isn't large enough to endorse a long position.

Many people can plan a trade, but not all have the ability to analyze the risk and manage the risk in a manner that ensures their financial survival in the markets when things go wrong. And believe me, they will from time to time.

There are three main risk management techniques that I wish to discuss here:

Frequency

In trading and investing, frequency refers to the number of positions we will open. The issue with many traders/investors is that they will try to take all opportunities they see and open positions with only a marginal chance for success. They do this due to fear of missing opportunities and profits in the markets.

Successful traders/investors have the discipline to be more selective in their opening of positions and take only those trades that meet specific criteria outlined in their plan and that offer a high probability for profits. As a new trader/investor, you should limit the number of trades you take. This will force you to look for the right opportunities to trade rather than jumping in on any small move in the markets. Remember, even if you miss an opportunity, there is likely another one coming along very soon.

Duration

The second technique is duration, or the amount of time spent in the position. The longer you spend in a position, the greater the chance for adverse price movement. This is why investors take on much greater risk in the markets than traders do. When we focus on smaller time frame charts, we have less profit potential but also much less risk. Trading on smaller time frames reduces the risk we face in our trades.

This does not mean that we should not look to profit from longer time frame positions. You can compensate for the increased duration risk by reducing the other two factors of size and/or frequency. Longer term traders and investors can still manage risk well.

Duration may also need to be turned down when overall volatility in the markets rise. Rising volatility causes more drastic price swings. As a new trader who is unaccustomed to trading these swings, you are best served by reducing your exposure to them by trading in smaller time frames

Volume

Volume is the most important aspect to your risk management plan.Tweet: Volume is the most important aspect to risk management plan. Volume for a trader/investor is the share size we are taking per position. Obviously, most people want to profit as much as possible, but by taking a larger share size, we are also increasing our risks. Volume should start as practice, in a simulated account, with no money at risk. After successfully practicing you may increase your risk with minimal shares. If you keep doing well, gradually increase your share size.

The keyword in the last sentence is gradually. Many traders feel they must go from 100 to 1000 shares, or 1000 to 10000 shares. This increases your risk ten times! You are much better off by no more than doubling your share size or risk for every step and only do so if you are achieving a positive win/loss ratio. When you risk more money in a position, there is a psychological effect that you will notice. Watching profits and losses increase exponentially can wreak havoc on a new trader's psyche. This may cause you to panic and exit positions too soon or to hold onto losers as you become frozen with fear.

If you are not trading or investing well at any time, you should immediately examine your risk management. The first thing is to reduce your volume (share size). Secondly, be more selective in your positions and turn down the frequency. Lastly, you can also reduce the duration of trades to offset volatility.

Everyone has a different balance of these risk management tools that they should be using.

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Market Mood Swings And How To Benefit From Them

You must have heard many news like - market dropped due to some political upheaval in the middle east or the market soared due to some referendum in Europe. In the age of globalisation, all the markets and businesses across the world are intertwined, hence any geopolitical event has the potential to move the global markets.

But where does that leave the investors? What should be their ideal approach to counter such uncertain situations? The good news is - whether markets fall or rise, it's an opportunity for the investors. Here's how.

Investors In The Market Cycle

The reason we say that whether market falls or rises, it's always an opportunity for the investor is because if the market falls, all the stocks on your watch-list, most likely, will be in the buying range. And when the market rises, it's a perfect point for you to sell the stocks which have reached their target price.

The key point is - if you have a long-term perspective in stock investment, it will be your armour against all the uncertainties of the stock market.

Let's take a look at the market phases which comprises the market cycle.

The Bear Market

The bear market is a market condition where the prices of the securities fall considerably and the market goes through a significant downturn. In such situations there is widespread pessimism about stock prices and a lot of panic selling takes place which further escalates the downturn.

Though it's a nature of the market to swing up and down, intraday traders and short-term investors, who deal in huge quantities, have no other option but to sell their holdings to minimise their losses.

However, long-term investors have an advantage in this phase, as they can choose to hold their stocks while they also have an alternative to average their existing stocks and buy new stocks. Always remember, the bear market is a perfect opportunity to enter the market and build a robust portfolio.

Market Accumulation Phase (Consolidation)

This phase takes place after the markets have hit the bottom and some value investors think that the market situations is good to buy as the worst is over. Valuations of stocks are very attractive in this phase while the market sentiment is still bearish. Which makes it an ideal time to enter the market. In the accumulation phase, prices are flat, as the disillusioned sellers start selling while the wise investors pick it up at a healthy discount. Owing to such turn of events, market starts to pick up.

To get through such phases, investors should just be patient and hold their stocks. Giving in to your impulse of selling stocks due to continuous consolidation will only bring you losses. It's just a phase which passes sooner or later.

The Bull Market

The bull market simply means that the market is on its upward drift. The market index goes high and all the major stocks start soaring. This is the phase investors invest for. One thing investors should ensure while going through this phase is that it's not a buying period, it's the time to review your portfolio and sell stocks which have reached their target price. In a way, all the investment, and calculated risks you take while the market was down pays off when you reach this phase. If you make the right choices, you will be handsomely rewarded.

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