TRADING & INVESTING TERMS
What is Risk Management?
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:
- Maximum risk amount: Traders and Investors should first decide how much they are willing to lose in a trade or investment without breaking their portfolio. This amount is used to calculate the remaining steps.
- Identifying security type: Some security types have higher inherent risk than others. For example, an Options trade has higher risk than the underlying Stock. Trading Futures contracts has higher inherent risk compared to the underlying commodities itself. Based on the Risk Tolerance, maximum risk amount, type of trader, the right security should be identified.
- Identifying position size: Based on the security type and maximum risk amount, the quantity of the securities to be traded is calculated. This ensures that the maximum risk amount is not breached.
- Identifying stop loss: There are various strategies available to identify the stop loss. One of the powerful strategies is Supply & Demand strategy. Pinnacle Method is built on Supply & Demand strategy. Based on the strategy followed, security picked, the direction of the trade and the technical indicators used, the stop loss level is determined.
- Understanding other Risks: There are other risks involved in trading, such as, overnight carrying cost / interest rate, gap in trade opening (trades opening gap up or down the next trading day), margin used and its carrying cost and volatility of the security used.
- Managing the Risk: A comprehensive risk management plan is key to avoid unwanted losses. This plan should be put in place before entering into the trade to avoid losses due to excessive volatility, emotional judgement, significant economic activities and important news & events in the market.
How do you manage your risk in trading?
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.
Risk & Reward
What is Reward to Risk Ratio (RRR):
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).
Why is it important?
- It is helpful to manage the risk of capital deployed.
- By calculating the reward to risk ratio, an investor will be able to find good quality trades.
- It guides an investor if they should continue or exit the trade.
- It assists in setting the target price and stop-loss price.
What do you decide first?
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.