If I have to point out a single reason why majority of traders are losers, It would be lack of following trade management and risk management. Trade Management and Risk Management is the most important technique to be used in active trading but actually it is least practiced. Lack of discipline can cause you to wipe off all gains made in 1 year in a single trade that goes against you.
Planning Your Trades
It is a common saying in military “Every battle is won before it is fought.” The phrase implies that planning and strategy – not the battles – win wars. Similarly, successful traders often quote the phrase: “Plan the trade and trade the plan.” Just like in war, planning ahead can often mean the difference between success and failure.
Stop-loss and Target (T/P) points represent two key ways in which traders can plan ahead when trading. Successful trading is actually is a game of probability so is betting. When the probability to win is high, than to loose only then you must place your bets.
Conversely, unsuccessful traders often enter a trade without having any idea of the points at which they will sell at a profit or a loss. Like gamblers on a lucky or unlucky streak, emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits often entice traders to imprudently hold on for even more gains.
Stop-Loss and Take-Profit Points
A stop-loss point is the price at which a trader will get out of position because the trading idea has been invalidated and he will take a loss on the trade. This happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the “it will come back” mentality and limit losses before they escalate. For example, If you are long on a stock or index you will place stop-loss below the support and If you are short the stop-loss has to be placed above resistance. You must take profits when the risk reward ratio turns unfavourable for you at the given price point. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation takes place.
What are the effective stop-loss and Profit targets
Setting stop-loss and target price is a function of technical analysis and psychology. For example when you are long a stock before results have been declared and huge expectations have been built about the results, It will always be a prudent action to book the profit ahead of results even if the desired target price has not been achieved because the weight of expectations can prove be too heavy to bring the stock down irrespective of the result numbers.
Moving Averages represent the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the five-, nine-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a stock’s chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.
Another great way to place stop-loss or take-profit levels is on support or resistance trend lines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. Just like moving averages, the key is determining levels at which the price reacts to the trend line and of course, with high volume.
When setting these points, here are some key considerations:
· Use longer-term moving averages for more volatile stocks with high beta value to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
· Adjust the moving averages to match target price ranges; for example, longer targets should use larger moving averages to reduce the number of signals generated
- Adjust the stop loss according to the market’s volatility; if the stock price isn’t moving too much, then the stop-loss points can be tightened.
- Use known fundamental events, such as earnings releases, as key time periods to be in or out of a trade as volatility and uncertainty can rise.
The Bottom Line
Traders should always know when they plan to enter or exit a trade before they execute. By using stop losses effectively, a trader can minimize not only losses, but also the number of times a trade is exited needlessly. Make your battle plan ahead of time so you’ll already know you’ve won the war.
My Personal Risk Management Strategy for Trading
I have a two-fold approach, one for my short-term trades and another for my longer trades.
Short-term trades: When it comes to day trading, overnight trading, trigger trading, and extremely short swing trades, the absolute maximum loss that I am willing to incur is capped at 5%. And while 5% is the absolute maximum, I usually place my initial stop-loss order at 2%-3%. In fact, it is rare that I will risk my maximum 5% on a short-term trade.
For example, if I place a short-term trade on a stock priced at Rs 100, the most that I am willing to lose on that trade is Rs 5/-, or 5%. I would do this by placing a stop-loss order for the stock at Rs 95/-.
Longer-term trades: When it comes to swing trading, position trading, and micro-cap investing, the absolute maximum loss that I am willing to incur is 10%. And while 10% is my maximum risk threshold, I typically place a stop-loss order of 7%-8% on longer-term trades. It is rare that I will risk my maximum 10% on a longer-term trade.