Lesson Five
Risk Management in Stock Trading
Learn to control risks and manage the transaction scale reasonably
Risk management is the job of balancing the return opportunities and potential losses from investment choices. This work can help reduce potential losses and increase potential gains. It can also help protect traders' accounts from losing all their money. Traders run at risk of losses when they open positions. The bigger the position, the greate
For traders at all levels, accepting risk management is an important step towards becoming a successful and resilient market player. Whether you are a beginner trader or an experienced professional, keep in mind that the goal of risk management is not to eliminate risk completely, but to understand and control risk in a way that supports your trading objectives. By constantly learning, understanding information, and adapting to market changes, you can develop a strong risk management framework to improve your transaction performance and support your financial goals.
Risk management is an essential yet often overlooked prerequisite for successfully conducting active trading. After all, without a proper risk management strategy, a trader who has already gained substantial profits could lose everything in just one or two bad trades. So, how can one develop the best techniques to mitigate market risks?
Plan your deal
As Sun Tzu, a Chinese military general, famously said: " Every battle is won before it is fought."This means that planning and strategic —— rather than fighting —— is the key to winning the war. Similarly, successful traders often quote this sentence: " Plan to trade, trade to plan."As in war, planning ahead often means the difference between success and failure.
Stop Loss (S/L) and Take Profit (T/P) points are two critical methods traders can plan in advance when executing trades. Successful traders know the price they're willing to pay and the price at which they're willing to sell. They can then measure the resulting return against the likelihood of the stock achieving the target. If the adjusted return is sufficiently high, they will execute the trade.
Conversely, unsuccessful traders often don't know when to exit trades for profit or loss. Much like whether the gambler is on a winning or losing streak, emotions begin to take over and dominate their trading. Losses tend to make people persist in hopes of recouping their money, while profits may entice traders to hold on imprudently for greater gains.
Set stop-loss and take-profit points
The stop-loss point is the price at which the trader sells the stock and bears the trading loss. This often happens when the results are less than traders want. These points are designed to prevent the "it will come back" mentality and limit the losses before they expand. For example, if a stock falls below key support levels, traders often sell as quickly as possible.
the other hand, the profit target is the price at which a trader sells a stock to lock in gains from a trade. This is when risk considerations limit the potential for further upside. For instance, if a stock approaches a key resistance level after a strong rally, a trader might opt to sell before a potential consolidation phase.
How to set the stops more effectively
Setting stops and stops usually uses technical analysis, but fundamental analysis also plays a key role in timing. For example, if traders hold stocks before earnings and the market expects earnings too high, they may want to sell before the news, regardless of whether the stop price is hit or not.
Moving averages are the most popular method for setting these points as they're easy to calculate and widely followed by the market. Key moving averages include the 5-day, 9-day, 20-day, 50-day, 100-day, and 200-day averages. The best setup approach is to apply them to stock charts and identify whether prices have historically reacted to them as support or resistance levels. This has been covered in previous lessons.
Another good way to set a stop or gain is to use a trend line or resistance line as support or resistance. These can be drawn by connecting previous highs or lows when volume is significantly above average. The key is to determine the level at which prices respond to a trend line or a moving average and, of course, to consider whether the volume is large.
When setting these points, note the following key points:
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When setting these points, note the following key points:
- Use a longer-term moving average for more volatile stocks to reduce the likelihood of meaningless price fluctuations to trigger stop-loss order execution.
- Adjust the moving average to match the target price range. For example, longer targets should use larger moving averages to reduce the number of signals generated.
- Stop losses should not be less than 1.5 times the current high and low range (volatility), as they may be executed for no reason.
- Adjust your stop loss according to market volatility. If the stock price is not volatile, the stop loss can be tightened.
known underlying events (e. g. earnings release) as critical time periods to conduct or exit trades, as volatility and uncertainty may increase.
Control position
Reasonably control stock positions according to market conditions and individual risk tolerance. When the market uncertainty is high, reduce the positions appropriately to reduce the potential risks.
Diversification and hedging
To make the most of trading, never put all your eggs in one basket. If you invest all your money in a single idea, you risk massive losses. Remember to diversify your investments - across industries, market capitalizations, and geographic regions. This not only helps manage risk but also creates more opportunities for growth.
Downside bearish options
If you are approved to trade in options, buying downside puts (sometimes called protective puts) can also be used as a hedge to prevent losses from failed trading. The put option gives you the right to sell (but no obligation) the underlying stock at the specified price. Therefore, if you hold XYZ stock at $100 and buy a six-month $80 put at a premium of $1.00 per share, you will effectively stop losses when the price falls below $79 ($80 strike price minus the $1 premium paid).
Avoid emotional trading
Do not be controlled by market sentiment and short-term fluctuations, and avoid blindly chasing up and down. Investors should remain calm and make investment decisions based on the company's fundamentals and long-term development trends.
Regularly assess and adjust your portfolios
Market conditions are changing dynamically, and investors need to regularly check and re-evaluate their portfolios and make timely adjustments. For example, sell stocks that perform poorly or have bleak prospects and buy stocks with potential.
Use financial derivatives to hedge against risks.
For experienced investors, financial derivatives such as options and futures can be used to hedge. For example, by buying putting options or short futures. However, this approach requires high expertise and experience.
This concludes the Risk Management in Stock Trading lesson. Please use the menu below to navigate to the lesson of your choice.