In our previous article, we covered all the ways in which you can aquire or increase your trading capital. The next step towards becoming a full time trader is to understand how you can guard your money. Fundamentally, you should refine your strategy enough to limit its loss making days. Once that is covered, you might be tempted to go all out on your strategy and use up all your capital. We suggest that you refrain from doing that because a significant loss in capital can reduce your profit percentage for successful trades and demoralise you. In this article, we will cover the different ways in which you can guard your trading capital.
Money or Risk Management
Money management is the most important concept in trading. Like we mentioned in our previous article, try not to risk more than 1 or 2% of your capital in a single trade. If you start with a capital of INR 1,00,000 and make losses in 20 consecutive trades at 1% per trade, you will still be left with INR 87,160 after the 20 trades. On the other hand, if you risk 5% of your trading capital per trade, at the end of 20 trades, you will only be left with INR 35,848. The reason many people are unable to cut their losses is purely psychological. If a stock was available at INR 100 and you went long on that and but found that unfortunately the price had moved down, as a good trader, you should keep a stop loss at 98 and exit your position. But someone who brings emotions to trading will refuse to exit at 98 hoping that the price will bounce back, only to find that it has fallen by a few more rupees. The bottom line is to get emotions out of the way while managing risk.
Risk to reward ratio
Simply put, the risk:reward ratio is defined as the risk you are willing to take with a security for it to reach a defined target. To calculate the risk to reward ratio, you can use either the monetary value or pips. If a stock is available at INR 50 and you think it has the potential to reach INR 100, it means that you are willing to risk INR 50 to get a reward of INR 100. The risk reward ratio of that particular trade for that particular stock would be 1:2. A pip denotes the smallest amount by which a security’s value can change. To define the risk to reward ratio using pips, consider how many pips you are willing to risk to reach a target. If you are risking 2 pips to reach a target which is 10 pips away, the risk to reward ratio for that trade is 1:5. Make sure to never take trades where the risk is greater than your potential reward. Even with continuous losses, you can ensure that your capital is protected by calculating and going with trades which have a high risk:reward ratio. If you make sure that all your trades have a risk to reward ratio of 1:2, then only a third of your trades have to be profitable for you to break even.
Another important technique used by investors and traders to protect their capital is hedging. Although hedging is mostly used by long term investors to protect their capital against short term market fluctuations, it is still an important tool which can be used to safeguard your money. When you purchase a vehicle and insure it, you are making sure that you can handle the repair costs in the event of an accident or mishap. Similarly, hedging is like insuring your capital against a negative event. But this doesn’t completely prevent losses. If you are properly hedged, the effects of the losses can be minimised.
Hedging usually involves trading in derivatives to offset any loss that you make in equity. Derivatives include futures and options which we will cover in a different article. If you are long on a security in equity and anticipate a short term down fall, you can buy put options of the same security which allows you to sell the stock at a certain strike price. If the price of the stock drops below the strike price, your capital will be protected by the gains in your put option.
What’s the downside?
Using high leverage can eat up your capital before you know it. Using high leverage could be tempting as the profits it can offer with successful trading can double or triple the profit you could’ve made otherwise. But the same holds true for your losses.
Despite placing a stop loss order, you might incur additional losses if the price moves up or down with a gap. It can move past your stop loss without crossing its price and when that happens your order might not get triggered. This happens rarely but it always helps to keep an eye out for sudden movements.
Hedging requires a good amount of capital. If you have to split your capital between equity and derivative, your capital might stay guarded but your profit will reduce too. It also requires years of trading practice to understand and properly implement a hedging strategy.
You can never know when a situation might arise which requires your capital to be guarded. But if you go into trading with the knowledge and techniques required to protect your money, you might just have the best strategy in the market. Irrespective of the indicators and screeners you use, proper risk management is the Holy Grail when it comes to trading. So, make sure that you always have procedures in place to safeguard your capital. Happy trading!