Risk management is a skill that all successful traders must have and strengthen daily. This skill is essential because risk comes with the job of trading. A trader can make 90% winning trades, but if they mishandle 10% of losing trades, they can lose money on a net basis. Hence, why it is imperative that you take steps to lessen the risk taken every day as a trader.
Risk management Techniques
“Plan the trade and trade the plan”. Plan your strategy and stick to it, that’s the number one rule because it’s the only way risk management will work.
Another great way to minimise your risk is to practice your trading techniques using the demo version of a platform. Demos are usually free and allow you to get the same trading experience without using real money. Here you can better refine your trading strategies and methods to be better prepared when trading in the real market.
Stop-loss points & orders
A stop-loss point is a price at which a trader will sell his/her stock and take a loss on the trade. The points are designed to prevent the mentality that the loss will come back causing traders to continue to hold on to the security. It limits losses before they escalate.
After determining your stop-loss point, you can place a stop-loss order. This order automictically executes a sell when your security reaches the stop-loss point to ensure that the loss does not increase.
Take-profit points & orders
On the other hand, a take-profit point is a price at which a trader will sell his/her stock and take a profit on the trade. The take-profit point is executed to prevent traders from holding an upturn position for too long when the risk of a downturn is high.
Once you’ve determined your take-profit point, you can place a take-profit order. This order automatically closes out the open position when the security rises to the take-profit point to collect the profit.
The entire goal of a day trader is to place trades where the potential reward outweighs the potential risk. Therefore, a trader should be aware of the potential risk and potential reward before entering a trade. A risk/reward ratio is the amount of money you plan to risk compared to the amount of money you believe you can gain.
How to calculate reward/risk ratios:
Divide your net profit, the reward, by the price of your maximum risk.
E.g. You notice that XYZ stock is trading at $24, down from a recent high of $30. You believe that if you buy now, soon XYZ will go back up to $30. You have $3000 for the investment so you buy 125 shares of XYZ. You also place a stop-loss order at $20 and your take-profit order at $30. Now, you are willing to risk $4 per share to make an expected return of $6 if the stock goes back to $30. You will make $6 for every 125 shares equaling $750. You paid $3000, so you would divide 3000 by $750 giving you 4. That means that your risk/reward ratio 4:1.
While the unpredictability of the market is one of the reasons we love it, we must be careful not to get caught up in the excitement of it all. Plan your trades, practice your executions and trade smart!
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