Profit is a key component of the stock investment process, although being able to minimize losses should be as crucial as the former one. Prices can fluctuate very rapidly, and a properly analyzed transaction will not necessarily turn out successful. For that reason, traders must have a plan when executing their orders. Stop loss, target level, and risked capital can contribute to a disciplined approach to trading. Although these strategies will not protect against every possible loss, they may help to prevent unnecessary risks.
Why Risk Management Matters
For many new traders, the main goal is to find stocks which have potential to increase in value. At the same time, it is crucial to think about scenarios when the opposite situation occurs.
Without proper planning, many traders might hang on to their losing trades, waiting for recovery. Others might risk the total amount of money which they are able to lose in one trade. In both cases, this behavior might lead to risks for the trader’s funds.
Managing the risks involves the understanding that the losses are inevitable while trading. The objective here is not to minimize all losses but to ensure that each loss is not too large. This can help traders base their decisions on the strategy rather than on prices.
What is a Stop-Loss?
A stop loss order is a type of instruction issued with an aim to restrict losses from a trade. In other words, a stop loss order informs a trader when to leave a position as a result of an unfavorable price move.
In case you bought a stock at ₹200 and set a stop-loss order at ₹190, you will suffer a loss of ₹10 for each share after the stop-loss is triggered and the order is executed at this price, disregarding any transaction fees.
The level at which you will set a stop-loss will depend on how risky your trade is and how much you are willing to lose from a price move. However, setting the stop-loss too close to your buy-in price may lead you to leaving a position because of regular market movements. Setting it too far from the purchase may expose you to a greater loss.
Setting a Realistic Target
A target is the price at which a trader plans to book a profit. Deciding this level before entering a trade helps avoid making choices based only on excitement or fear.
Suppose a trader buys a share at ₹200, sets a stop-loss at ₹190 and chooses a target of ₹220. The potential loss is ₹10 per share, while the potential gain is ₹20. This gives a risk-to-reward ratio of 1:2 before charges.
The ratio helps traders compare the possible gain with the amount they are prepared to risk. However, a favourable ratio does not mean the trade will succeed. The target should also make sense based on market conditions, price levels and the trading strategy.
How Much Should You Risk Per Trade?
A risk limit is not universal and varies from one trader to another, being dependent upon capital, experience, financial obligations and willingness to take risks.
One way to determine an amount of the risk to incur in a single trade is risking a limited part of the trading capital. For instance, a trader having ₹50,000 of the trading capital setting a 1% risk limit will need to maintain the risk at ₹500.
In case the stop-loss level is set ₹5 lower than the entering price, the trade made on 100 shares will have a risk of ₹500, without taking into account commission and possible slippage.
This way the trader determines his/her position size. However, the total risk level should be taken into account, especially in case there are multiple trades which could suffer from one market event.
Build a Trading Plan Before You Start
A well-written plan makes it easy to trade effectively. Before you open Demat account, it is important to establish the reason for making such a trade and also the points at which you would either realize a profit or cut your losses.
Another thing to note is that traders must not increase their positions in order to recover from an initial loss. This may lead to higher losses and poor decision-making without adequate analysis.
If you are planning to trade, then it would be wise to have knowledge on the various order types, the broker’s fees, etc. It is important to know what your chosen brokerage offers after opening a demat account and a trading account.
Conclusion
Stop losses, targets, and appropriate position sizing are among the fundamental techniques of minimizing risks in trading. These are not ways to make sure of making profits, but rather techniques to enable traders make up their minds about the amount of money they are prepared to lose before engaging in trading. Maintaining a trading history and adhering to a proper strategy will minimize impulsiveness in trading. Before initiating anything, one needs to be aware of the potential dangers and select a platform that is endowed with such features. 5paisa enables traders to examine the trading tools.
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