How to manage risk like a pro?
Central dogma of a trade 4.1
Hello traders,
Time for a gentle reminder of the complete framework for a TRADE:
We have discussed 1, 2, and 3 till now.
Today, I will talk to you about 4, i.e Risk Management.
Why do you have to manage Risk?
Simply because without managing risk, you will not survive in the market in the long term. The risk of ruin, i.e the probability that an individual will lose substantial amounts of money through investing, trading, or gambling—to the point where it is no longer possible to recover the losses or continue will eventually occur to you.
How to manage risk like a PRO?
A 4 quadrant framework for risk management (RM) is a great way to think about Risk.
BIG LOSS: To AVOID this is the 1st priority for any trader including you. The 1st quadrant we strive to avoid at all costs.
We achieve this by using a Stoploss. A line on the sand below which if the price moves, you sell with no questions asked.
How and where should you place your Stoploss is a topic for another article. For now, read the only thread you need to on this below.
SMALL LOSS/SMALL GAIN: The next step once we have managed not to lose big is to lose small (or gain small). This is the 2nd priority as a trader.
We achieve this by selling some into strength. We can do this by selling X shares when the price reaches a multiple of the risk, R (the Stoploss %).
For example, the SL is 5%. If your gain is 10%, then you are at 2R gain.
Now, you can sell 50% of your position. In this way, your trade is sure to not lose even if your original SL is hit. If after selling 50% at 2R, you trail your SL to the BUY PRICE; you make sure you have a small gain (at least).
You can use other combinations of % position to sell and the R multiple at which you sell.
BIG GAIN: This is the ultimate goal of your trade, to lock in big huge gains. Once you made sure to avoid a big loss and that you are sure to take a small gain, this is the 3rd and TOP priority.
The only way to do this is to let the winner RUN until the uptrend ceases to exist (or a downtrend sets in). This is done by using trailing Stoploss, i.e manually shifting the SL up as the price moves up. This makes sure that you don’t exit your winner prematurely while also making sure that you preserve a bulk of your gains in case the trade reverses. This is the HOLY GRAIL of trend trading.
What do you use as the trailing SL?
Following are some of the indicators/pivots you can use to mechanically trail your SL:
The Swing low (in the Timeframe you trade):
A few points below the swing low is a great place to place your SL.
Supertrend (ST):
Supertrend is a great indicator that shows the trend and also takes the intrinsic volatility of the stock into account. A price above the ST means an uptrend and a price below means a downtrend.
An SL just below the ST also works great and is mechanical. (setting I use is 10,3 for ST)
Key moving average:
depending on the timeframe of your trade (and the holding time horizon), key MAs viz 10 DMA, 21EMA, or 50 DMA can be used. The stock should be bouncing off the key MA and an SL just below the MA should work well.
So to sum up, the 4 quadrant framework of RISK MANAGEMENT:
Use Stop-loss to avoid a big loss.
Sell into strength to make sure you have a small gain (or a small loss at worst).
Use a trailing stop-loss to score a big gain.
If you want to learn more about risk management, Mark Minervini’s 1st book out of 3, Trade like a stock market wizard has 2 dedicated chapters on it. I highly encourage you to read those.
The 4 quadrant framework I discussed today is something that I 1st learned from Himangshu Sharma (the chartist) on Twitter.
That is all for this weekend.
Next week I will discuss a sister concept of risk management “Position sizing”. Stay tuned.
Follow me on Twitter, if you haven’t already.
~ Prakash (SH)
Last week’s article on
