Every investor understands that the greatest rewards often come from the greatest risks. But with the right trading risk management strategies, you can achieve greater rewards without facing significant risk. Whether you’re new to the trading game or looking to sharpen your skills, the following guide will help you adapt to the risks associated with stock trading.
What Is Risk Management in Stock Trading?
For some traders, the market is as cruel as the laws of nature: what goes up must come down. In 2020, one amateur trader turned $15,000 into $1 million — only to lose it all. While such catastrophic losses aren’t uncommon, they’re certainly possible for traders who lack experience or the right risk management strategy. Risk management simply refers to the techniques used to prevent or mitigate losses from your investments.
Keep in mind that trading risk management isn’t just a concern for active traders. Anytime you invest in the stock market, you should take careful measures to protect your investments. And if you decide to engage in active trading — meaning you buy and sell stocks within a few weeks or even days — it’s all the more important to take steps to avoid major losses.
Trading Risk Management Strategies
When it comes to risk management in trading, no single strategy will ever be foolproof. But if you learn some of the following trading risk management strategies below, you’ll be better equipped to navigate even the most volatile and complex markets and come out ahead.
Assessing Your Risk Tolerance
Before you implement any strategies for managing risk, you’ll first have to decide on your own risk tolerance level. While risk management refers to the way that you address and protect against risk, risk tolerance refers to how much risk you’re willing to take on when engaging with the stock market.
For example, if you have a low risk tolerance, you’ll want to take extra steps to protect against losses. But it’s also important to acknowledge a high risk tolerance and check yourself to ensure you don’t take on unnecessary risk. And never, ever invest more in the market than you’re prepared to lose.
Diversification
Diversifying your portfolio is always an important step when investing in the stock market. Investors should focus on two types of diversification: diversifying across asset classes and diversifying within asset classes.
Diversifying across asset classes means investing in multiple types of investments: stocks, bonds, real estate, or even things like precious metals or collectibles. Diversifying within asset classes means investing in stocks from multiple sectors (healthcare, tech, consumer staples, etc.).
Building a diversified portfolio will allow you to absorb more risk. For instance, if you opt for a mutual fund or index fund, you’ll have built-in diversification, which will give you greater flexibility in taking on riskier investments.
Using the 1% Rule
Many stock traders abide by the 1% rule. This means that you never invest more than 1% of your total account value on a single trade. If your total account value is $10,000, you should never invest more than $100 on a single trade.
Practicing the 1% will prevent you from experiencing catastrophic loss if the trade falls through or your stock performs poorly. And remember, you can always increase your investment if the trade is successful, though the 1% rule will continue to guide you in making incremental investment decisions.
Hedging
“Hedging” refers to the practice of taking the opposite position in the market to offset any possible losses from your primary position. For example, some traders may purchase put options to hedge against the decline in the value of stock holdings.
Hedging doesn’t have to be a permanent position. When trading activity subsides, you can unwind the hedge. However, hedging can be a strategic move to protect against uncertainty or extreme forms of market volatility.
Stop-Loss and Take-Profit Points
Experienced traders should already be familiar with stop-loss points. A stop-loss point is a strategy that allows you to cut your losses by selling an underperforming stock at a predetermined price. For example, if you buy stock in Company A at $100 per share, you can set a stop-loss point of $50. Then, if the stock price drops suddenly, you’ll have a point at which you sell the stock before incurring an even greater loss.
A take-profit point is the exact opposite. A take-profit point is the price at which you sell the stock for a profit. Day traders commonly do this when a stock is approaching a resistance level after an upward move, which allows you to take full advantage of the stock’s value.
Day traders use a variety of technical analysis techniques to make crucial, data-driven decisions about both their stop-loss and take-profit points. Moving averages, for example, will give you a better idea of how a stock has historically performed and can also tell you which direction the stock’s value is moving.
Downside Put Options
Downside put options are a specific type of hedging strategy used in options trading. You can purchase a downside put option to protect against losses from a trade that fails to turn out the way you’d hoped.
How does a downside put option work? Imagine that you own stock in Company A for $100. You can buy a six-month put with a strike price of $75 and a $1 premium fee. This means you will be protected against any price drop below $74 ($75 strike price minus the $1 premium fee). Downside put options can, therefore, be very effective in options trading, though they require some extra steps that may intimidate inexperienced traders.
Maintaining a Positive Risk-to-Reward Ratio
Each time you make a trade, you should make sure to maintain a positive risk-to-reward ratio. This means that the potential gain on a trade outweighs the risk of a potential loss. In other words, it’s unwise to invest more than you stand to gain from any one trade.
Some traders go even further by aiming for a ratio where the potential gains are at least twice the potential loss. In simple terms, this means that before you invest $100 in a trade, the potential gains should be at least $200. This primarily applies to day trading, in which short-term gains are the immediate goal, as opposed to the long-term growth of other stock investors.
Maintaining Consistent Risk
It’s easy to let emotions take charge when making investment decisions. The promise of a “sure thing” can easily short-circuit your other risk management strategies. That’s why it’s vital to stay consistent. Don’t make snap decisions based on the promise of a golden opportunity or sink your entire investment budget into a trendy new startup.
Some traders find that it helps to take breaks periodically. Doing so can give you a chance to reassess your budget and your trading strategy and reflect on your most recent trading activity. Then, when you return, you’ll have the clarity and insight you need to continue making effective stock trades and navigate risk with greater wisdom.
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