We come to stock markets for making money. Generally, Stock Market are expected to give higher Returns on Investments though most of time a regular trader or a frequent investor gets into losses or reap extremely low returns. To make money as a trader, it requires a lot of discipline, saving on trading costs, self research, trading techniques and analytical skills.
An important ingredient for making money is to manage your risks.
Risk Management is normally perceived as an enemy to ones profit. Traders believes that they can make more money, had the risk management measure were not in place. Treating Risk Management as an obstacle is a common belief, which according to me is a absolutely wrong. Risk Management saves your capital and profits from from undue movements and helps you protect your ROI. Small profits accumulated in various trades gets wiped off in one single loss making trade. Let us see few techniques that the Smart Traders uses to manage their risks.
Diversification
If you are a investor with medium to long term investment horizon, then this is the most suitable risk management methodology for you. The diversification means investing in diverse or unrelated industry or stocks such that one stocks performance does not have a bearing on other. Diversification could also be achieved with investment in different asset classes. As such even if a stock or industry or a particular asset class goes through the tough times, the returns from the others covers it up. The best example will be mutual funds that invests in various stocks even if they have a strong confidence in one. They even have a investment strategy where they do not increase their exposure in single stock or single industry beyond 5% to 15%.
Scrip Selection criteria
This is a risk management strategy used by both investors or traders. The selection criteria of scrip may also be termed as avoiding scrip which are not upto mark. The criteria may include the daily or monthly volume, market capitalisation, stock price, Bid – Ask spread, dividend history etc. This selection calls for the type of strategy getting implemented and the size of investment.
Stop Loss
This is the most popular risk management tool implemented mostly by traders or brokers. This means to cut out the trade at a small loss if the direction of price movement is not favourable. Their is a huge debate on the levels of stop losses and mostly people keep their own trading pattern in mind before defining their own. Stop loss not only prevent the increase in loss but free the margin capital for next trade as well. The stubborn traders always hate stop loss as they feel the stop loss gets hit and then market move in the direction they were predicting, thus making loss for them. But still it is a must do in trading as prevents big losses and capital wipe outs.
Calender Spread
It is a mix of trading strategy and risk management and normally opted by risk averse traders. A calender spread is taking a reverse position in two contracts of a scrip. For example, buying Stock A Jan futures and selling stock A Feb futures. As such whenever the price of stock A will move up and down, the price of Jan and Feb futures will also move in tandem. However the movement may not be of the same magnitude. This will lead to increase or decrease in between the price difference, also termed as spread. This movement in spread is always slow as compared to price movement therefore it not only creates an opportunity for trade but also attract lesser margins.
Options
Options are sometimes also referred as ‘Insurance’ in stock markets because when you buy an option after paying a premium, you get a right to exercise in the event of adverse movement. Suppose, we bought 1000 shares of Stock A @ Rs. 200 per share. Now whenever the price will move up we will make profits however whenever price will move down, well make loss. Now, if buy a Put Option at a strike price of Rs.200 by paying a premium of Rs. 5 per share, let us see what happens in a scenario analysis.
If price move to 250, we will make a profit of Rs. 45,000{(Rs. 250 – Rs. 200 – Rs. 5 premium) X 1000 shares}
If price remains at Rs.200, we will loose an amount of Rs.5,000{(Rs.200 – Rs.200 – Rs.5 premium) X 1000 shares}
If price falls to Rs. 150, we will loose an amount of Rs.5,000{((Rs.150 – Rs.200) + (Rs.200 – Rs.150 – Rs.5 premium) X 1000 shares}
Thus, we can see that when we loose money in stock we make an equivalent money from options thus protecting us from huge losses. There are various other combination of trading and Risk Management which is been used by traders. You may learn more about the same in our Online Derivatives course at our Academy.
Ratio Trading
It is much similar to calender spreads. The only difference is that instead of using same stock or scrip different other scrip are used for risk protection. Say use of Silver or crude contract with Gold, using Nifty with any nifty stocks, etc). Since the two stocks or scrip selected may not have a similar price thus a ratio is derived as per their price and traded. It is important that these two scrip should have a reasonable coefficient of correlation or in simple words should move in tandem.
So, we have seen various techniques for managing risk in markets. If you are a trader or investor in the market or looking to enter markets, then it is must to have a risk management strategy before in place even before placing the first order. It is just like wearing warm clothes in winter or walking vigilantly in dark places or knowing the air bags while boarding the plane. Playing in the markets without any risk management technique can make your life difficult after only few days of turbulent markets.
