Risk Management: Intro
Managing your risk in trading, keeps your trading account alive, long enough to learn the skillset, and eventually earn money from the stock market.
In trading, your trading capital is your bloodline. To protect your capital knowing about risk management and how to do it is important.
Besides, don’t think risk management is important for trading only. It is as important for investing purposes also.
First Rule: Don’t lose money
Second Rule: Don’t forget rule number 1.
~Warren Buffet (link)
But the way you deal with risk in trading and investing is totally different. In this article, the primary focus is on stop loss for risk management purposes.
Stop Loss: Your first line of defense
The first, foremost and most important risk management rule that you need to learn and apply well in trading is: Stop Loss.
Stop Loss is that price, where you exit your trading position.
For example, you bought shares of Reliance at 1000/- and you think if it falls below ₹ 920/-, it can fall more. Then, if you place an order in the system to sell your shares if price touches ₹ 920 is called placing the stop loss.
You see, even if your trading system is very good, not every trade will go in profit. This is part of the trading business, and you can not predict which trade will go into profit & which one will go into loss.
The only thing you can control is the amount you lose when your trade goes into loss.
To limit the amount of loss per trade, one of the most important decision you have to make ‘before’ you enter in any position is:
- At what point, you will decide that according to your trading signal, the trade has failed?
- If your system has provision for locking partial profit, then what will be that point?
Why to decide stop loss beforehand?
The reason for deciding stop-loss beforehand is simple.
When you have not decided beforehand, then you will have an approximate idea about where will you exit your position, in case of loss.
This leads to a high chance that when your trade is giving you more loss, you will hope that it will get into profit soon.
And this praying hopeful mind is the most common reason of trading losses.
Many times when a trade fails, it fails big. Sometimes, big enough to wipe your account.
Decide before taking the trade and then place it in the system.
How to place stop-loss orders?
Stop loss orders are trigger-based orders which you can place with your broker. These orders are not sent to exchange like other orders.
When you place a stop-loss order, you broker holds these orders with itself, till the stock/future instrument has traded at or above or below(depending on it being sell-stop or buy-stop) the trigger price.
Once the stock/futures price has triggered as per the order, you broker send your order to exchange as normal order. Depending on which type of Stop Loss order you selected, your order is either sent as market order or limit order.
Currently, stockbrokers allow two types of Stop Loss orders:
SL-M: Stop Loss at market. In this order, as soon as your stop loss price is triggered, the order to exit the position is done at market price.
This is my preferred order type in case of a fast-moving instrument like BankNifty.
SL: Stop Loss. This is a limit order. Means when you enter trigger price, you also enter the price at which you would like to exit from position.
Thus when stop loss is triggered, your order will enter the order into the market as limit order.
How to decide your stop loss?
Remember I mentioned, that, you need to know when you will exit the trade, ‘before’,entering the trade. That is important.
Equally important is knowing where to place your stop loss.
You should be managing risk in trading, but being too cautious isn’t good either. You can’t place your stop loss at arbitrary price points or something similar.
There should be a tested reason within your trading system about placing stop loss.
Let’s say you trade using RSI based distribution method. Now look at the chart below of NIFTY on 26th march 2018:
Now as per this method, you enter into ‘long’ in NIFTY on 5th bar of 26th April. So, where should be your stop loss in case this trade doesn’t go positive?
In this case, it should be low of 25th April 2018 as that is the nearest pivot from where the market bounced back. Breaking that low will be a continuation of the downward movement of NIFTY.
Similarly, every trading system has points where the trade is no longer valid. That is your stop loss.
The next question is how much to trade for such stop loss points?
There are several methods to manage that, try them all and see what suits you!
This is most common method of risk management. This one was first mentioned by Dr. Tharpe when talking about skillset of various successful traders he interviewed.
He mentioned that most of traders follow a percentage method of risk management, which is nothing but keeping your risk per trade to a fixed percentage of total trading capital.
The average percentage is ~2% of trading capital.
Let’s say you started trading with the capital of Rs. 5,00,000 (five lakh). And you plan to trade NIFTY index futures.
Now the lot size of NIFTY is 75. And let’s say your average stop loss size is 50 points. Which means your risk per trade per lot is :
75*50 = 3750 /-
At 2%, the risk per trade that you can take is : 5,00,000 * 0.02 = 10,000/- . Which means the number of lots you can buy or sell in a single trade is :
10,000 / 3750 ~= 3.
Thus at percentage of 2%, for a stop loss of 50 points for trading NIFTY futures, at trading capital of Rs. 5 Lakh, you can trade 3 lots of NIFTY futures only.
The issue is, when you are starting out with real trading with real money, strictly following this method is good enough. But, it is still a beginner’s technique.
Once you have mastered this method and mental calculations are fast enough, you can use a slightly advanced, more active version at same risk levels.
Advanced version (percentage method):
There is a good chance that NIFTY will get close to your stop loss before moving into profit’s direction. So, when you enter the trade initially, you trade with 2 lots only.
And if, NIFTY moves close to your stop loss (without hitting it), then they rather then adding 1 more lot to trade, they add 2 lot.
The reason being, now the difference between entry point and stop loss is less, so even entering 2 lots, the total risk per trade is same.
Continuing with above numbers, rather then entering into 3 lots, you enter into 2 lots and keep a watch on price movement.
Then, NIFTY moves towards your stop loss & is now 20 points away from your SL trigger price. At this point you can enter into 2 more lots, & update your Sl order to 4 lots.
This was your average stop-loss points are now 35, which means total risk is: 35*4*75 = 10,500/- . This is ~2% risk per trade rule.
Now to the part where I caution about this method, this one requires you to:
- Either keep a consistent watch on prices and enter when you get an opportunity
- Enter the limit order price with SL order already of 4 lots and set up an alert to know when your trade is executed.
Try both and then choose the one that works well for you.
Percentage based method (converted into points) is one of the most common methods used by retail traders in the stock market. It works well in most cases.
Professional Stop Loss techniques
Professional traders handle multiple trades at any given point and they do employ multiple trading strategies. In such a scenario, calculating points and position sizes of each instrument isn’t easy and sometimes not optimum use of capital too.
Thus, professional traders employ risk management rules and stop loss methods, which are sometimes retail traders are not even aware of. I am listing two of them here:
Volatility based stop loss:
This is an adaptable risk management technique. Which means a fixed percentage of trading capital is not followed. The trade is big or small based on the volatility of the future or option being traded.
For example, in case of the range-bound market, stop losses can be decided by using support and resistance of particular stock or index future. As, the range is normally not very large, slightly bigger quantities are traded in each trade.
As you can see from the same chart of NIFTY with ATR values:
When our long trade got triggered, the ATR is near 40, whereas later is coming down all the way to 24-25, which means you can add more lots as market keeps on getting higher.
Though, you have to be careful not to add near the end of the move.
[Rarely market keeps on moving in one direction. Most of times market is in a range. So, with enough study of charts you get fairly good idea when the current trade move is nearing its end. Time to book partial profits.]
Whereas in case of a break out trade, or trending market, stop losses are decided according to ATR (Average True Range) & nearest big bar’s (candle chart) high or low.
Just to be clear, this technique is not used in case of small duration trades like intraday or 15-min, 30-min trade setups as ATR and volatility can’t be rightfully known in such small durations.
Time-based stop loss:
This technique is used along with other stop loss methods. This is used to avoid locking your trading capital in a trade which just moving sideways for quite sometime. It is good to exit the trade and then enter again when the prices start to move.
The other scenario when this technique is used is when you enter into a trade and it immediately goes against you. In such scenario, you exit the trade rather then waiting for stop loss to get hit. You can always enter again.
Man who can both be right and sit tight are uncommon ~Jesse Livermore
Now, when to exit and when to stay put is a tough decision to make. That’s why this technique is not used by retails traders.
This technique takes time to develop and thus should be slowly integrated in your method as per your trading journal results.
Once you have developed certain level of skills and it is visible with your growing trading account, then only these professional risk management techniques make sense.
Risk Management is one of most important skill to master if you want to make a living by trading. Trading is serious business, and for it to be successful, you should handle it like a business.
Risk Management acts like inbuilt insurance for your trading business, taking care of your trading capital.
Every trading system goes through a phase when you see a series of loss-making trades. A robust risk management system makes sure that such a phase doesn’t take you out of the market or wipe out your account.
Thanks for reading so far, if you have any suggestions or doubts, please ask in the forum and I will try to respond as early as possible.