Art of Managing Trading Risk

Recently, we received the following question regarding risk management numbers.

Could you please explain how to manage trading Risk ?

Risk management is a critical element in a trading plan. The two elements primarily involve risking reasonable amount of money on each trade, and knowing when to get out of a trade if and when it is going against you. We will discuss both of the elements below:

1. The amount of money that you risk on a stock or a trade. Investing too much of your trading capital on one trade increases your risk. Common sense dictates that it is not the right thing to do. Many people have rightly suggested that investors should diversify their portfolios. Diversification does not increase returns, but it reduces your risk.

The question then comes up is, how much money should I risk on a trade ? The amount of money that you should risk on a stock depends on the capital you have to trade, your mental and personal makeup to tolerate risk, and your goals. Normally, it is suggested that a trader should not risk more then 2-5% of the available capital on one particular trade. This is a good rule of thumb; however, you should evaluate your personal circumstances and risk tolerance before taking on a trade.

2. The second element in risk management is knowing when to exit a trade that is going against your position. We believes that this should be planned prior to entering the trade. None of us are perfect traders, and we do make mistakes. We either buy or sell the wrong stock or our timing on the stock is not correct. Trading many times is a humbling experience. So at some point, you have to swallow your pride, and cut your losses. We believe that an unemotional but an objective way will be beneficial in the longterm.

askStockGuru.com provides a reasonable approach to this question: when to cut your losses. We believe that the amount of money that one should risk on a particular stock depends on the volatility of the stock. If you risk too little on a trade, you may lose the opportunity. For example, BIDU, a Chinese Internet company, is very volatile, as well as rewarding to many traders. If you risked 3% by setting a stop order or by exiting the trade, you would most likely exit the trade too quickly. Basically, because the stock is volatile, you need to risk more then 3% when trading BIDU.

Similarly, a trader should not risk more than what is required on a trade. For example, risking 20% on GE trade does not make sense. Bidu and GE have different volatility profile.

The risk management numbers intend to provide a balance. We incorporate the volatility profile of a stock, and crunch the numbers based on past behavior of the stock to come up with a reasonable estimate of how much you should risk on a trade. There is a no method to calculate the optimal amount. However, we believe that a reasonable approach over a long term will pay off.

Based on the volatility of a particular stock, we provide a range. For example, you bought a stock at $100.00, the risk management section suggest you risk between 3% and 7% on a stock. In such a case, you may hold on to the stock until it reaches $97 to $93. This is based on the thought that 3% to 7% is a normal fluctuation of prices in that particular stock. However, we suggest that if it falls below 7%, you should seriously reevaluate the assumptions you made when entering the trade.

Risk management is a critical element in your trading plan
Take reasonable positions on a trade and diversify
Lastly, risk a reasonable percentage on each trade.

askStockGuru.com provides analysis and recommendations for over 4000 stocks for FREE. Askstockguru.com has developed this and other indicators for trading stocks. Manish Shah has a B.S. in Engineer from Illinois Institute of Technology and a Masters in Business Administration from Washington University. He has been trading markets for over 10 years.