First Steps in Risk Management

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Risk Management concept image with business icons and copyspace.

Risk Management concept image with business icons and copyspace.

One of the key elements for success in investing and/or trading is having a proper risk management. This issue is mandatory to your success, determining whether you end up profitable or losing.

Everyone dealing with the uncertainty must have risk management, especially when you run a leveraged/margin account where your positions are based mostly on borrowed money. Being careless on a loan, in this case a loan linked to your level of success – wouldn’t be smart!

Since probably all of us reading this article have no monetary and influential resources needed to move a market, and the only thing we are able to do is to participate in a move the big and resourceful “money” has already initiated, then nothing would be 100% certain before the expected move, and our results, whether we like it or not, are bound to probabilities.

While looking for opportunities in the markets, unprofessional investors and traders are being driven mainly by the shining profit potential. Most of the times, the potential loss doesn’t get the needed attention. Troubles start when the potential loss that hasn’t been estimated properly becomes a reality, and the harm to the portfolio is inevitable.

Once you pull the trigger and get into a position, you have no control over the results the market is going to give you, but you do have control over two important derived issues that are completely up to you.

First, the equity quantity you got into the position with. Being bound to probabilities, all positions must be approximately in the same level of potential loss as you never know which one is going to fail and which is to gain (even if you are “certain” about it…). You have the control over the quantities you buy or sell so that in the worst case the overall position shouldn’t lose more than a certain fixed pre decided amount of money (e.g. starting with as low as say 50$ maximum loss per position, raising it to 100$ after a successful period of time, 200$ later, and so on).

For an example, suppose you want to buy a stock priced at 30$ and your stop loss point is at 26$. There is a risk of 30-26=4$ for each stock you buy, and if you are willing to risk a fixed say 80$ (approximately) per position, then you should buy 80/4=20 stocks for that position. If the price of the certain instrument doesn’t allow you to limit your potential loss to the level you’ve already decided, you simply don’t trade or invest in it.

Many times, a position that looks “certain” urges us to put more money into it and make the “killing”… Usually those that look “certain” tend to disappoint, mainly if you don’t have enough experience in the markets.

Second, the mental ability to cut the loss at the spot you pre-determined, as any further delay can damage your portfolio much more than planned. Instead of giving the market “just one more chance”, – respect the fact you were wrong and cut the loss as soon as possible. If you see that mostly after taking out your stop it continues to go your way, check that you know how to determine the correct stop loss level rather than becoming skeptic about the stop loss necessity!

Summary:

When approaching the markets, pay attention first to your potential loss prior to your potential profit. Handling correctly your losses rather than handing your profits will determine eventually your overall success in the markets.

Determine the maximum loss you are willing to take in each position, and try to keep it constantly for quite a considerable period of time.

Respect your Stop Loss level and don’t give the market “another chance”.

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