Risk Management

Risk Management is a topic that maximum people aren't aware of and even those who are, find it rather uncomfortable to delve into. But in our educational series - #LearnwithUpstox , we've promised to make investing easy for you and have covered this topic in the simplest to understand words. Take a look to learn about the four points which make up the basis of risk management.

Welcome back to a new blog of ‘Learn with Upstox’. Risk management is a term that most people do not know about or find painful. So, what is risk management?

 Risk management is a very vast subject. In this blog, we will cover four main topics.

1.     Stop Loss

 Stop loss is an order meant to secure profits. For example, assume we bought stock for Rs. 200 and put a stop loss at Rs. 198. If the price reduces, this is a loss. Stop loss is an advance order to sell an asset when it reaches a particular price level. People who make decisions in the moment and don’t use stop loss face illogical loss.

 Let’s look at it in a technical and psychological way.

 Technical: Say share price is Rs. 500. Put the stop loss at a support, let’s say 200 moving average. Say that lies on Rs. 497 in a 15-minute time frame. Now go another 1 – 2 Rs. Below this to say Rs. 495. This is so that the stock price has space to bounce back from the support line, and you avoid an early decision. This is a logical stop-loss, which is put under logical support and above the resistance in case of short selling.

 Psychological: It feels bad when the stop-loss is hit. This is when you should not give in to the risk of passing this price through, because you may face more illogical losses. Trust your initial strategy. Do not feel pain when you hit the stop-loss and take action instead.

2.     Risk Reward Ratio (RRR)

 This is a simple mathematical calculation. Risk Reward Ratio (RRR) measures how much you could lose (risk) and much you could earn (profit) in a trade. Let’s say, the stock price is Rs. 500 and I put the stop loss at Rs. 495. So we have the stop loss of Rs. 5. So, as per the standard, I should put my target at Rs. 510, which means Rs. 5000 if we incur loss and Rs. 10000 if we make profit (Assuming 1000 shares bought). So, here RRR will be a stop loss of Rs. 5 and the target of Rs. 10, making it 1:2. So, this is a standard RRR. 

 If you are training and do not maintain your risk reward ratio, For example, my stop loss is Rs. 495 and the target is Rs. 503, which means I will earn Rs, 3000 but if I lose, it would be a loss of Rs. 5000. This is not a good ration. If you trade not matching with your RRR, then you are going to face losses. If the Risk Reward Ratio is less than 1:5 then you will not be profitable in the long-term. For example, as I reach target Rs. 507.5, stop loss Rs. 495, means our 1:1.5 RRR is maintained. This is standard for Intraday trading.

 For Intraday traders, I highly recommend not to invest in trades which have RRR less than 1:1.5. If I have bought a trade at Rs. 500 and my stop loss is Rs. 495, then the  target should be at least Rs. 7.5 higher, then the RRR will be 1:1.5. If trades are below 1.15 RRR, it could mean long-term loss.

 In swing trading, the minimum RRR should be more than 1:3. If there is a stop loss of Rs. 5 then targeting higher is possible as we have time to grow.

3.     Risk Per Trade

RPT (Risk Per Trade) needs to be planned before stepping into the market as you won’t find it on the chart. Books and successful people always advise not to risk more than 1% to 2% of your trading capital and I personally recommend 2% risk. Suppose if you have an account of Rs. 1 lac, should you trade with only Rs. 2,000? No. The stop loss is placed at a loss of Rs. 2000. You will definitely use more than Rs. 2000 depending on the levels and the trades.

So, RPT should be 2-2.5% for any trade.

4.     Position Sizing

 RPT has to be matched with position sizing. Position sizing is the quantity of shares one should trade in. If I am getting any opportunity, with a breakout at 500 and can go as high as 510, it doesn’t tell you the quantity you should buy. So, if you have one lakh capital to invest but, you won’t invest all of it because you cannot take the overall capital amount. You can’t take the full leverage.

 A simple formula to calculate this is RPT divided by stop loss in rupees. For example, I have an account of Rs. 1 lakh, where I take a risk of Rs. 2000 and the stop loss is Rs. 5. So, RPT (2000) divided by stop loss (5) is 400. This 400 is the maximum number of shares that you can buy. If you bought more than 400, then the outcome will be a loss of more than Rs. 2000 and also you will break the risk management rules.

 If your loss is only Rs. 2000, which is 2% of your capital, then you should not worry. Losses are inevitable in the stock market. The secret is not to avoid them but to manage them. To manage them, use the position sizing formula. You can buy shares up to 400 but not more than that. 

 Risk management is an important tool in the success of the traders. These are the main four pillars of risk management. If you follow these, there is a very high probability that you will become a profitable trader.