Risk management and avoiding common pitfalls during trading

by Pooja Late so cut

Trading in the share market is full of risks and uncertainties. Since the stock prices are strongly correlated with the market situations, any deviations from expectations cause risks to the investor's portfolio. Risk management thus becomes very crucial to traders. Risk management involves identifying, measuring, evaluating, and mitigating risks associated with a trade.

Risk management is more important in intraday trading than long-term investment because in Day trading the stock could fluctuate more and the trader has to keep a close eye on the stock throughout the day.

Nevertheless, every trader must have a risk management strategy that will help them to minimize their risks. Some of the standard risk management practices that one can follow are:

1) Keeping a stop-loss: A trader must know how much loss he is willing to bear before entering a trade. The stop loss will execute the order if the share price breaches that level. This way the trader will have control over his losses. This is a free service and should be optimally used by all traders.

2) Diversification of portfolio: We all must have come across the term Do not put all eggs in one basket. Well, diversification of one's portfolio is also a risk management strategy. Instead of investing all their money in one stock, investors diversify their holdings across different sectors, industries, and sizes of companies as well as asset classes. It acts as a hedge in case one asset class falls. This way an investor can spread his risks so that exposure to any one stock or asset class is limited. This also keeps the portfolio well balanced.

3) Do not over-leverage: In intraday trading, brokerages offer margin to trade. A trader needs to pay just 20% of the share price he wants to buy and the balance is paid by the brokerage as leverage. This allows traders to trade higher volumes of shares. While leverage helps the trader to multiply his profits, it also multiplies losses. Therefore, it is quite unwise to use up all your leverage. Usually, an exposure of just 1-2 times the money with the trader is advisable.

4) Invest in blue-chip companies: For risk-averse investors, the best option is investing in blue-chip companies. They are well-established companies with strong fundamentals and track records. These stocks are relatively less risky and safer options. They are less affected by market movements.

Apart from following proper risk management strategies when trading in equities, it is also important to avoid making some common trading mistakes.

1) Not knowing when to exit: Not knowing when to exit a trade could be very risky to your investment. Most often, when the stock is giving good results the trader will want to hold onto it longer which could prove detrimental when the market swings in reverse direction. The same is true when the stock is making losses, and the trader wants to hold onto it hoping that the trend will reverse. Failing to cut losses could wipe out any profits made.

2) Over diversification of portfolio: Diversification of portfolio helps in minimizing risks. The trader can benefit from positive developments in various market segments instead of just one. However, in day trading or short-term trading, having too many open positions would require more time, concentration and constantly keeping track of several markets. This could be very stressful for a novice trader.

3) Over-trading: Buying and selling stocks too frequently is called over-trading. While there are no limits to trade, it is common knowledge that any more than three trades during the day for an intra-day trader is considered over-trading. This could lead to high transactional costs in the form of brokerages.

4) Not having a trading plan: Having a trading plan that clearly lays out your trading strategies is very important to be a successful trader. A trading strategy will help in determining the entry point, exit point, stop loss, and position sizing.

5) Emotional bias: Emotional biases result from the inability to control one’s own emotions when making a financial decision and letting your emotions take over the rational decision-making process. This includes loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion. Many times a trader despite having put a stop loss, the trader will remove it as he feels the stock price will retrace and go up. This is an emotional bias that puts his portfolio at major risk. Not giving in to the temptation is very important in stock trading.

While profits and losses are part and parcel of trading in the share market, controlling the amount of both is in the hands of an investor. By using proper risk management tools such as putting a stop-loss, diversifying of portfolio and avoiding over leverage one can limit their losses in the market. Also, by avoiding emotional bias, over-trading and diversification of portfolio one can be an effective trader.

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