Whether you are a day trader or a position trader, it is likely that you will always have two primary objectives: avoiding risk and pursuing high returns. By carefully balancing these objectives, you can achieve your long-term financial goals and remain ahead of ordinary traders.
However, while these objectives may be somewhat intuitive, avoiding risk is something that is much easier said than done. Out of our natural need for instant gratification, it can be all too easy to open positions that are not justifiable on paper. While patience is indeed a virtue, it is something that is rarely found on Wall Street.
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Risk management is perhaps the most important component of any trading strategy. Though identifying, managing, and controlling risks may not be the most glamorous step in the trading process, it is often what makes the difference between continuous losses and long-term success.
Fortunately, taking just a few small steps can help you avoid risk and improve your overall approach to trading. In this article, we will discuss eight things you can do to reduce the risk of trading.
- Minimize Marginal Trading Costs
Trading is a practice that can come with many costs. Depending on the trading platform you are using, you may need to pay fees for every trade you make or, in some cases, even for every individual share you trade. Even if these fees are small, they can still significantly skew your risk-reward calculus.
If executing a trade costs $5, and you are trading 100 shares valued at $1, this means that you will need to wait until the price reaches $1.05 to simply break even. A 4 percent positive price swing, for this position, would functionally register as a loss. If you could instead trade on a platform without marginal costs, you could decrease your exposure to risk. These platforms are ideal for people making multiple trades per day.
- Trade Indexes, Not Stocks
Diversification is a principle that allows traders to effectively reduce their asset-specific exposure to risk. Even if a single stock (or other security) has a bad run, with a diverse portfolio, this will not really matter. The general growth of the market will carry this trader forward.
With the principle of diversification in mind, many traders will trade index stocks, rather than the stocks themselves. Indexes connected to S&P 500 or Dow Jones Industrial Average are generally moving in a positive direction. Instead of betting on a single stock to perform well, bet on the market’s performance instead.
- Use Options to Control Exposure
Options give individuals an opportunity to buy or sell at a specific price on a specific date in the future. Options are also an excellent mechanism for controlling your exposure to risk. If a stock’s value is hovering around $100, purchasing $95 or $105 option can limit the worst-case scenario and cause your risk to be functionally contained. Purchasing both call (buy) and put (sell) options at multiple different price points—a practice known as spreading—will enable you to have total risk control.
- Issue Tight Stop Losses
Stop losses cause a trade to be automatically triggered once a price has reached a certain level. Instead of monitoring price charts all day, stop losses make it easier to plan in advance and exit your position as soon as the moment is right.
Stop losses are one of the most effective tools for combatting the risks of trading psychology. When stocks are rising, it can be tempting to press your luck and try to keep going. When stocks are falling, it can be just as tempting to cut your losses early. Instead of making decisions during the emotional heat of the moment, make these decisions in advance when your mind is in a more objective place.
- Scale your Positions
Scaling is a practice that involves entering multiple different positions as the market changes. Suppose a stock is currently trading for $100. Instead of simply dumping 10 percent of your wealth into the stock and hoping it increases in value, it will be safer to enter into a position gradually. Planning to invest an initial 2 percent at $100 and then 2 percent more at $102, $104, $106, and $108 will reduce your exposure to risk—if the stock never reaches these higher levels, you will not need to risk additional capital.
- Follow the News
Fundamental analysis is one of the most important components of trading and one of the surest ways to avoid sudden surprises. The value of any speculative instrument will be connected to events occurring in the outside world. By paying close attention to the news, you can have a much better pulse on where the market is likely to be moving.
Additionally, it is important to note that the market typically overreacts to developing news stories. By entering into positions early, you can remain ahead of the market’s collective momentum and enjoy relatively risk-free gains.
- Use Technical Indicators
Technical analysis may be even more important than fundamental analysis. Without numbers supporting each of your prospective positions, trading is really just a glorified form of gambling.
Technical indicators come in many different forms. Channel indicators, momentum indicators, volume indicators, and other indicators can all be used to evaluate where the market is likely to be moving. Technical analysis will be especially important for day traders and traders making multiple moves between financial reports.
- Test New Trading Strategies on Paper
There are seemingly countless different trading strategies available to choose from. While each of these strategies has its share of pros and cons, there is no denying that practice will be needed in order to be successful. Instead of risking actual capital, use a trading simulator to test any strategy you are considering using. Being able to backtest these strategies against real-world data can help you determine whether the strategy is likely to produce the gains you are hoping for.
Conclusion
The more you can do to reduce the risk of a given position, the more likely you will end up with a profitable exit. In the world of trading, risk management is just as important as identifying possible opportunities. By keeping these essential risk management strategies in mind, you can become a successful trader.
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