Trade The Journey

Trade The Journey

Risk management in investment and trade: How to minimize losses and maximize gains

Risk management is one of my favorite topics to discuss when talking about investment and trade management. It’s often overlooked in favor of capturing profits. Everywhere you look,  online, websites, YouTube channels, and articles mostly focus on profits which is great. A lot of sites make trading and investing sound easy and boast about their winning trades. But a key question to ask these spectacular traders, is how much did you lose on losing trades?  A sound risk management plan is what keeps you in the market to earn profits.

I look at trading and to a certain extent investing as a competitive sport. You are competing against the best, most well-capitalized, and brightest traders looking to earn a profit. It’s so easy to not have a plan for risk management because it leaves you open to make decisions on the fly. 

Who wants to adhere to a plan when you can have the freedom to do as you, please? I do. I would liken risk management to a diet. If you’ve been on a diet, you can attest to how hard it is to maintain a diet in the face of so many temptations. It’s so easy to slip for the day and promise yourself that you’ll resume the diet tomorrow.

The only difference is that if you skip the diet for today, you won’t lose money. So, what does risk management involve, I’d say a plan, discipline, and the proper psychology.

Plan:

What is your plan when you enter the trade or investment? I’d say it involves taking an assessment of where the market is and where it’s likely to go. I’d also say it’s about assessing the probability of the market arriving at the destination within a certain time, especially if you’re trading. I primarily trade options, so I must be precise in the timing and probability of the future direction of the market.

Once you have written down the current market assessment and the potential developments, what industry will choose to trade or invest in? What is the industry’s current trajectory? Where are we at in the business cycle, meaning is the economy contracting or expanding? What industries do well in a contractionary versus an expanding economy?

After I have all of this written down, I’m looking to focus on the stocks and the technical patterns that might provide me with some profits. I use reference levels, but some people use technical indicators, Fibonacci ratios, moving averages, and the list goes on. It’s up to you to determine a strategy that best fits your personality.

The next and final part of the plan is determining my entries and exits. There’s an art to entering and exiting a position that I will cover in a later article. I then look to find out where I am going to place a stop. A stop is a market order that allows a position to be executed at a certain price whether for entry or an exit. Some people don’t use stops, I am not one of those people.

Anything can happen in the markets and a position that was once profitable can turn into a loser faster than you think. I’ve personally been in positions where I didn’t have a stop and ended up losing more than I anticipated because I didn’t have a stop. Typically, I like to open a position with a 3:1 reward-to-risk ratio. I use the barchart chart tool to visually see my reward-to-risk ratio on the chart. Once you have your plan set, and you enter the trade, the next two parts of risk management come into play.

Below is an example of the reward-to-risk ratio could be used:

Discipline and the Proper Psychology:

I mentioned this earlier but it’s worth repeating, anything can happen when you’re in a position. Traders and Investors have different reasons for entering and exiting a position and you’ll never why they are doing so.

An excellent resource to build your trading psychology is the book “Trading in the Zone” by Mark Douglas. This book can shorten your learning and experience curve by giving you an understanding of how the markets really work. The basic premise of his book and lectures is that anything can happen for any reason.

Here is a link to the first of a four-part lecture by Mark Douglas entitled “Trading in the Zone”

If we know that anything can happen for any reason, then we must have the discipline to stick to our risk management plan even if we feel that the position may turn in our favor. I’ve been in positions that I exited adhering to my risk management plan that would have turned into a profitable position if only I would have kept the positions open. But on the other hand, I’ve been in positions that lost a lot of money hoping a turn like this would happen.

It’s best to cut your losses, adhere to your plan, and live to trade another day. This is where your trading psychology comes into play. You must understand that the market will always offer opportunities and remaining in a losing trade hoping it will turn in your favor is really a waste of time and energy. If you choose to remain in the losing position, every passing day will add to your stress.

You’ll constantly be waiting for a turn while watching the losses add up. Trust me, I’ve been in this position and the losses added up quickly. Before you know it, you’ll be forced to exit and when you get to that point, you’re exhausted and just happy the pain is over.

But what about the trade that you missed, the trade that could have worked in your favor.

As much as the markets are about technical patterns, economic events and developments, they are also about your mentality or psychology.

Avoiding huge catastrophic losses should be the goal of every trader and investor. Taking profits is another aspect of trading and investing but I rate it second behind risk management.

When is the proper time to close a position and take your profits? I’d venture to say there is a time but you’ll also leave some of the profits in the market. Some of the best traders in the world leave profits on the table. One of my favorite traders to learn from is Linda Raschke, and she has mentioned in numerous interviews, that she rarely is able to capture full profit by remaining in the trade.

In order to receive the entire profit from the position you’d have to have the ability to know when the stock has topped or bottomed or when the stock’s direction is about to reverse. This is very hard to do on a consistent basis.

I find it’s best to find a profit target, the profit you’ll be satisfied receiving according to your goals and close your position when you reach it. This way you the leave the uncertainty involved in trading and investing between the amount you are willing to lose and the amount you’re willing to profit.

When you think about it, a trading and investment plan can make your life easier. You aren’t trading or investing haphazardly, you’re implementing your plan with a goal in mind. To remain in the market by having capital available should be the goal of every trader and with a plan, you’re ensuring that you are able to do so.

I hope that this short article helps you on your trading and investing journey. Of course, this is just a short summary, but it should be enough to get you started on your journey. Remember the markets are fraught with individuals no longer able to trade or invest because they shunned the importance of a risk management plan.

It can happen, just don’t let it be you.

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