Risk management helps cut down losses. It can also help protect a trader's account from losing all of his or her money. The risk occurs when the trader suffers a loss. If it can be managed it, the trader can open him or herself up to making money in the market.

It is an essential but often overlooked prerequisite to successful active trading. After all, a trader who has generated substantial profits can lose it all in just one or two bad trades without a proper risk management strategy. So how do you develop the best techniques to curb the risks of the market?

This article will discuss some simple strategies that can be used to protect your trading profits.

Key Takeaways

  • Trading can be exciting and even profitable if you are able to stay focused, do due diligence, and keep emotions at bay.
  • Still, the best traders need to incorporate risk management practices to prevent losses from getting out of control.
  • Having a strategic and objective approach to cutting losses through stop orders, profit taking, and protective puts is a smart way to stay in the game.

Planning Your Trades

As Chinese military general Sun Tzu's famously said: "Every battle is won before it is fought." This phrase implies that planning and strategy—not the battles—win wars. Similarly, successful traders commonly quote the phrase: "Plan the trade and trade the plan." Just like in war, planning ahead can often mean the difference between success and failure.

First, make sure your broker is right for frequent trading. Some brokers cater to customers who trade infrequently. They charge high commissions and don't offer the right analytical tools for active traders.

Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan ahead when trading. Successful traders know what price they are willing to pay and at what price they are willing to sell. They can then measure the resulting returns against the probability of the stock hitting their goals. If the adjusted return is high enough, they execute the trade.

Conversely, unsuccessful traders often enter a trade without having any idea of the points at which they will sell at a profit or a loss. Like gamblers on a lucky—or unlucky streak—emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits can entice traders to imprudently hold on for even more gains.

Consider the One-Percent Rule

A lot of day traders follow what's called the one-percent rule. Basically, this rule of thumb suggests that you should never put more than 1% of your capital or your trading account into a single trade. So if you have $10,000 in your trading account, your position in any given instrument shouldn't be more than $100.

This strategy is common for traders who have accounts of less than $100,000—some even go as high as 2% if they can afford it. Many traders whose accounts have higher balances may choose to go with a lower percentage. That's because as the size of your account increases, so too does the position. The best way to keep your losses in check is to keep the rule below 2%—any more and you'd be risking a substantial amount of your trading account.

Setting Stop-Loss and Take-Profit Points

A stop-loss point is the price at which a trader will sell a stock and take a loss on the trade. This often happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the "it will come back" mentality and limit losses before they escalate. For example, if a stock breaks below a key support level, traders often sell as soon as possible.

On the other hand, a take-profit point is the price at which a trader will sell a stock and take a profit on the trade. This is when the additional upside is limited given the risks. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation takes place.

How to More Effectively Set Stop-Loss Points

Setting stop-loss and take-profit points is often done using technical analysis, but fundamental analysis can also play a key role in timing. For example, if a trader is holding a stock ahead of earnings as excitement builds, he or she may want to sell before the news hits the market if expectations have become too high, regardless of whether the take-profit price has been hit.

Moving averages represent the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the 5-, 9-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a stock's chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.

Another great way to place stop-loss or take-profit levels is on support or resistance trend lines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. Like with moving averages, the key is determining levels at which the price reacts to the trend lines and, of course, on high volume.

When setting these points, here are some key considerations:

  • Use longer-term moving averages for more volatile stocks to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
  • Adjust the moving averages to match target price ranges. For example, longer targets should use larger moving averages to reduce the number of signals generated.
  • Stop losses should not be closer than 1.5-times the current high-to-low range (volatility), as it is too likely to get executed without reason.
  • Adjust the stop loss according to the market's volatility. If the stock price isn't moving too much, then the stop-loss points can be tightened.
  • Use known fundamental events such as earnings releases, as key time periods to be in or out of a trade as volatility and uncertainty can rise.

Calculating Expected Return

Setting stop-loss and take-profit points are also necessary to calculate the expected return. The importance of this calculation cannot be overstated, as it forces traders to think through their trades and rationalize them. As well, it gives them a systematic way to compare various trades and select only the most profitable ones.

This can be calculated using the following formula:

[(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)]

The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade. The probability of gain or loss can be calculated by using historical breakouts and breakdowns from the support or resistance levels—or for experienced traders, by making an educated guess.

Diversify and Hedge

Making sure you make the most of your trading means never putting your eggs in one basket. If you put all your money in one stock or one instrument, you're setting yourself up for a big loss. So remember to diversify your investments—across both industry sector as well as market capitalization and geographic region. Not only does this help you manage your risk, but it also opens you up to more opportunities.

You may also find yourself a time when you need to hedge your position. Consider a stock position when the results are due. You may consider taking the opposite position through options, which can help protect your position. When trading activity subsides, you can then unwind the hedge.

Downside Put Options

If you are approved for options trading, buying a downside put option, sometimes known as a protective put, can also be used as a hedge to stem losses from a trade that turns sour. A put option gives you the right, but not the obligation, to sell the underlying stock at a specified priced at or before the option expires. Therefore if you own XYZ stock from $100 and buy the 6-month $80 put for $1.00 per option in premium, then you will be effectively stopped out from any price drop below $79 ($80 strike minus the $1 premium paid).

The Bottom Line

Traders should always know when they plan to enter or exit a trade before they execute. By using stop losses effectively, a trader can minimize not only losses but also the number of times a trade is exited needlessly. In conclusion, make your battle plan ahead of time so you'll already know you've won the war. (For related reading, see "5 Basic Methods for Risk Management")