TRADING & INVESTING TERMS
Managing risk is one of the very important aspects of Trading and Investing. Without assessing, monitoring and managing the risk, the trade or investment may suffer losses bigger than expected. The key steps in this process are:
In trading, risk management is useful as it helps a trader to reduce the amount of loss. To manage the risk, a trader can plan before entering. They set stop loss, targets (taken profit), calculate the return, reward-to-risk ratio, and risk tolerance. It is better to diversify the investment, e.g., putting money in a different type of stocks and markets. They should plan when to enter and exit from the trade before execution. It is suggested to use the 1% rule that means the trader is advised not to put more than 1% of money at risk in a single trade.
The Reward to Risk Ratio (RRR) means calculating the reward that the trader or investor will be receiving relative to the potential risk on their investment. The more a trader risks, higher the chances of reward. The formula to calculate the risk to reward ratio is = (Target Price – Entry Price) / (Entry Price – Stop Loss Price).
Identifying Risk is more important than identifying Reward. Knowing the maximum risk, having a plan to manage the risk and monitor and execute on it protects a trader / investor from losing more money than expected. Once that is set, the Reward can be determined with confidence.