Up until now, we talked about various statistical concepts to gauge risk and return at both, individual stock level and portfolio level. We discussed in great detail important concepts such as mean, variance and standard deviation, returns distribution, skewness and kurtosis, covariance and correlation, beta, portfolio optimization, efficient frontier, Sharpe ratio, Treynor ratio, and coefficient of variation. While these statistical concepts can be utilized for managing the risk and return in trading, they are however more widely used to manage the risk and return in investing.
In this chapter, as well as in the next few, we will turn our attention towards risk management in trading and talk about concepts such as the basics of trading, entry, stop loss, target, risk-to-reward ratio, and position sizing.
To become a successful trader, it is necessary to focus on the following:
- Knowing how to take a trade
- Knowing when to take a trade and exit from a trade
- Paying utmost attention to risk and money management
- Ensuring that your emotions do not get the better of you
The first and the most important skillset that you need to possess is knowing how to take a trade. Trading decisions could be based on Technical Analysis, Quantitative Analysis, or, to a lesser extent, even Fundamental Analysis. Irrespective of which of these approaches is used, you need to have a solid understanding of the approach chosen and the methods that you use to initiate trades. Remember, if you want to take a trade, it means you are going long or short or deploying some kind of long-short strategy. To do any of these, you must be in a position to understand and forecast price trends. If you cannot decipher a trend, you certainly would not be in a position to decide whether to buy or sell or deploy a buy-sell strategy.
Secondly, you must also know when to enter and exit a trade. Timing is extremely critical, especially in trading. This is because when you trade, your holding period is relatively small, and you typically trade with leverage. Hence, if you get the timing wrong, your profit potential could reduce, or you could even suffer a loss. And the worst part is that all this could happen even if your view turns out to be right! Let us understand this using a hypothetical example. Let us assume that the futures contract of a stock, which has a lot size of 1,000, gave a bullish breakout at 515. After the breakout, let us assume that the price rose to 525 within minutes. Seeing the breakout and an increase in buying activity, a trader decided to enter a long position at 525 for a price target of 540 (reward = ₹15,000) while maintaining a stop loss of 517 (risk = ₹8,000). However, after the entry, the stock started falling, hit his stop loss (causing the trade to close out), made a low of 514, and then eventually rallied above 540. In this case, notice that although the trader’s view went right (the price did rise to 540), entering the position at the wrong time led to a loss of ₹8,000. Hence, timing plays a critical role in trading.
Speaking of trading would be incomplete without taking about Risk Management. In fact, risk management is arguably the most important part of trading. When you deploy your money for trading, your foremost objective should be to protect the capital that is deployed. Earning returns on the capital deployed should only come next. The biggest mistake those who are new to trading can commit is being lured by the potential of earning handsome returns, without paying much heed to the risks involved in trading. Being aware of the risks and implementing the right risk and money management strategies that suit your trading style and objectives can help to cut down losses and avoid capital ruin. This in turn would help you stay in the game for long. Remember, it takes time to construct a building but only seconds to destroy it. In trading too, the capital that you have built overtime can be lost in just a few bad trades, if you do not have in place a strategy to manage risk.
You must also have a strong control over your emotions and ensure that they do not get the better of you. Allowing emotions to take control of your mind can impair the decisions you make and lead to financial losses. As an example, at the time of entering a position, you must know beforehand at what level you will exit that position if your view goes wrong. And in case that level is hit, you must exit. Holding on to a losing position, even after the pre-determined stop loss is hit, on the basis of hope that price will eventually start moving in your favour is a recipe for disaster. We will talk more about the emotional aspect of trading in the next module, Trading Psychology.
Before starting your trading journey, the first question that you need to answer is how much money will I allocate to trading? Well, there is no definite answer to this, and it tends to vary from one trader to another. For instance, a person who has accumulated a savings corpus of 1 crore would not mind allocating 25 lacs to trading. On the other hand, a person with an accumulated savings of 30 lacs might be unwilling to allocate 25 lacs to trading and might instead allocate just, say, 8 lacs.
One good way that could help in deciding how much capital to allocate to trading is to ask yourself: how much of my savings can I reasonably afford to lose without having a detrimental impact on my finances? If the answer to that question is, say, 5 lacs, allocate a capital of 5 lacs to trading, and so on. Remember, this is the portion of your overall wealth (or savings) that you should be reasonably willing to lose if things do not go as planned. Thinking this way would help you in remaining calm and in ensuring that you overall finances do not come under a stress if your trading capital starts declining.
That said, you must also take into consideration the instruments in which you intend to trade. For instance, if you intend to buy stock futures or sell stock options and hold on to those positions overnight, you must be aware of the margins required to create such positions. As an example, if you want to buy a futures contract on a stock that has a margin requirement of, say, 5.5 lacs, you will not be able to take an overnight position if you have less than 5.5 lacs in your trading account. So, the sort of instruments that you intend to trade also has a bearing on the quantum of the capital you would want to set aside for trading.
In a later chapter, we will talk about a few critical things such as how much capital to allocate per trade, diversification etc.
Once a particular security has been selected and the direction of the trade has been determined (long or short), you need to decide on two things.
The first is the entry, wherein you need to decide the level at which you would be entering the trade. If you are trading multiple units of the security, you also need to decide whether you would do so in one go and at one price or in tranches and at different prices.
The second is the exit. This is where risk management primarily comes into play, given the uncertainty that exists at the time of entering a position. Your trade could either go right or wrong. If it goes right, what would be the price at which you would be willing to book profits and close out your position? This would be the target price of your trade. Similarly, if the trade goes wrong, what would be the price at which you would be willing to cut short your losses and close your position?
This would be the stop loss of your trade. These are the two questions that you need to ask yourself when entering a position. The worst mistake people do, especially those new to trading, is determining the target price but not determining the stop loss. This is an extremely dangerous way to trade, more so when you are trading with leverage. Remember to always have in place a stop loss when trading. The extent of your stop loss could depend on various factors such as risk tolerance level, quantum of capital in your account, nature of the trader (defensive, moderate, or aggressive), leverage, time horizon, reward expectations etc.
Let us start this section by talking about football. Even if a team has world-class players, a victory is never guaranteed. Before a game kicks-off, the coach of the team needs to study the opposite team meticulously and in advance. He then needs to devise tactics that would help his team to exploit the weaknesses of the other team while also taking advantage of the strengths of his own team. Once the game has kicked off, if the tactics deployed are not working well, the coach needs to make necessary amendments, by either changing tactics or by substituting a few players who are not performing as expected. While doing so would not guarantee a victory, it nonetheless could raise the bar, swing the odds in their favour, and possibly lead to a victory. Similar logic can be applied to trading as well.
Keep in mind that losses in trading are a part of the game. No matter how good a trader is, there will be trades that would go wrong. There will also be periods wherein a trader would regularly experience drawdowns. Mentally, you must be prepared for such situations. And how do you do that? Well, the answer is planning well ahead of time. To stay focused on your trading goals and to efficiently manage risks, it is critical to create a trading plan before you embark on your trading journey and then follow that plan rigorously once you start trading. What is a trading plan? Well, a trading plan is a document that consists of a defined set of rules that a trader must diligently follow when trading. The key advantages of a trading plan are that it ensures the trader stays disciplined, trades in an organized manner, and keeps emotions under control. A well prepared trading plan that suits your individual trading style and risk tolerance can go a long way in determining your trading success. As you gain experience in trading and as your goals change, you may need to modify your plan once in a while.
When you create a trading plan and embark on your trading journey, it is difficult to say beforehand how good the plan would turn out to be. The good news is you can always learn and modify the plan as and when needed. If the trading plan is not working as you would have expected it to, you need to find out the reasons why it is not working. Then, you need to take steps to address those reasons and remodify the plan. Also keep in mind that no two traders are the same. Every trader has unique set of trading objectives and risk profile. A plan that works well for trader A may not work so well for trader B, and vice versa. Hence, it is important to devise your own trading plan and adhere to it, rather than using someone else’s plan.
Below mentioned are some important things that you need to keep in mind before you embark on your trading journey. You could also consider this as a part of your trading plan:
Depth of subject knowledge:As said earlier, trading decisions could be based on technical analysis, quantitative analysis, or, to a lesser extent, even fundamental analysis. No matter what form of analysis you use, you must ensure that you have a strong understanding of the chosen approach before you devise trading strategies out of it.
Level of confidence:If you have ample knowledge of the approach you have decided to use, can you confidently trade by applying that knowledge? If not, it would be better to do paper trading until the time you gain confidence and are ready to trade with the real capital. Keep in mind, you need to be confident when creating positions and holding on to your trades. That said, being overconfident could be harmful.
Instrument to trade – Cash or Derivatives:Another important thing to decide is the instruments you intend to trade – cash, derivatives, or both. If you are new to trading, you would be better off by starting to trade the cash market first. As you gain confidence and your capital and risk-taking ability increases, you could then venture into the derivatives market.
Assets to trade – Equities, Commodities, or Currencies:Do you intend to trade equities only, commodities only, currencies only, or a combination of two or more assets? You need to decide on this as well.
Type of trading – Intraday, Swing, or Positional:You also need to decide on what type of trader you intend to become: intraday, swing, positional, or a combination? The reason why this is important is because depending on the type of trades you do, your strategies and risk profile would differ.
Use leverage wisely:If you decide to trade derivatives, you are likely to do so with leverage. Keep in mind that leverage is a double-edged sword. When used wisely and with proper risk management framework, it can help you profit handsomely. However, when misused, leverage can blow up your trading account very quickly.
Capital needed to allocate to trading:We spoke about this earlier in the chapter. Remember, only allocate that much portion of your overall savings to trading that you can reasonably afford to lose without having a detrimental impact on your overall personal finances.
Protect your capital:As said, your foremost objective as a trader should be to protect the capital deployed. Everything else comes next. A good approach would be to start slowly and defensively. While this approach would take time for your capital to grow, it will ensure that you do not experience severe drawdowns initially. Remember, if you start bad and your capital declines from 2 lacs to 1 lac, there is a drawdown of 50%. But to then come back from 1 lac to 2 lacs, your capital needs to grow by 100%, a task that is more difficult than you can think.
Time and Commitment:Before you start trading, ask yourself: do I have sufficient time to devote to trading, each day? Remember, as a trader, you need to constantly monitor the markets, identify trade setups, and manage your positions once you are in the trade. If you do not have the time to do this on a day-to-day basis, investing might suit you more than trading.
Patience and realistic expectations:Trading requires patience, having realistic expectations, constantly learning from your weaknesses, and improving on your strengths. Keep in mind that trading is not a get-rich-quick activity. You also cannot expect to become a successful trader overnight. It takes years of efforts and perseverance to become successful at trading.
Earlier, we spoke about a trading plan. Now, it is time to briefly talk about the things that a trading plan must include. While this is not an exhaustive list, following are some key factors that must be a part of your trading plan:
- How much capital to set aside for trading?
- Approach based on which trades would be taken (Technical/Quantitative/Fundamental)
- Filters that would be used to select securities
- Instruments on which positions would be taken (Cash/Derivatives)
- Assets on which positions would be taken (Equities/Commodities/Currencies)
- Would trades be intraday, swing, or positional?
- In case of multiple open positions, are the positions diversified across securities?
- Are the chosen strategies back-tested? Are the results favourable to initiate a trade?
- Maximum (as a % of total capital) you are willing to allocate per trade
- Maximum (as a % of total capital) you are willing to lose per trade
- Maximum number of positions (across securities) that would be open at any point in time
- Minimum reward to risk ratio per trade
- Orders used to enter and exit trades (market/limit)
- Maximum time for which a trade would be held
- Parameters based on which the entry price is chosen
- Parameters based on which the exit price (target price/stop loss) is chosen
- When entering a position in a particular security, would you do so in one go or in tranches?
- When in a winning position, would you add more (aka scale in) before the target is achieved?
- When in a losing position, would you reduce some (aka scale out) before the stop loss is hit?
- If a trade was a success, was it for the right reason or mere luck?
- If a trade was a failure, what went wrong and how to improvise on it
- Periodicity of performance measurement and review (daily/weekly/monthly etc.)
- Maximum capital drawdown, before a break would be taken to review reasons for drawdown
- If a trading break is taken, how long will it last before you resume trading?
- On any given day, are you mentally prepared to trade? If not, how to manage trades?
These are some important points that your trading plan must address. Sticking to your trading plan will ensure that you stay disciplined and take the right steps to up your trading skills and profitability. From time to time, you may need to modify your trading plan for factors such as changing market conditions, current plan not working out as expected, change in the goals and risk profile as you get better at trading etc.
Identifying Entry, Exit, and Reward Risk Ratio in Trading5 Lessons
Now that we have discussed the basics of trading, it is time to move ahead and talk about some critical aspects of risk management in trading. In this chapter, we will focus on entry, target, and the reward to risk ratio.
Stop losses, their types, and Leverage in Trading8 Lessons
In this chapter, we will talk about arguably the most important part of trading: stop losses. Besides, we will discuss leverage and provide some suggestions on stop losses.
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