One of the most important steps when making trading strategies is risk management. Regardless of how experienced you are as a trader or how much money you are investing, it is very important to consider different risk factors as a safety net. The main purpose of risk management is to identify any potential problems before they occur in order to prevent yourself from a large loss.
How to be Proactive when Managing Risk?
With risk management we want to be proactive, which means we have to plan ahead. One tool we can use when planning ahead is a stop-loss. A stop-loss order can be placed ahead of time that states when a stock reaches a certain price it should be automatically sold, protecting the investor from substantial money loss. Research should definitely be conducted for you to decide what price you want to buy and sell your stocks and how much of a range you are willing to allow.
Unlike the stop-loss strategy where you limit yourself at a certain loss point, a take-profit point is the opposite where it limits the profits that you receive. While this may be harder to comprehend why you would stop yourself from letting the stock grow more before you sell, the truth is you can never be certain when a stock price is going to drop after an uphill slope. Having a take-profit point allows you to sell your positions when they reach a certain price to protect yourself from any negative risks of a sudden down-turn.
Another important way to proactively decrease risk is to diversify. Diversification is a common technique that investors use to reduce potential risks by allocating investments is a wide variety of companies and industries. This strategy reduces risk and optimizes returns since different companies and different industries react differently to market events. It is also a good idea to diversify amongst different asset classes such as stocks and bonds as they will also react differently to market events.
I followed these steps before investing, now what?
After investing, it is important to keep up with your positions and continue to research the markets. Risk management is a continuous process, but allows investors to make greater profits with less probability of loss. Some ways to keep up with your investments are by following trends and having multiple quantitative strategies run at the same time. If these strategies have opposing results, however, you will have to use your own judgment to decide the right strategy to follow. If you decide to be more number focused and perform quantitative analyses, do not blindly follow the results and make sure the numbers make sense before you decide to make any changes.
Overall, risk management is a continuous process where the main goal is to be proactive about future risks instead of reactive. Trust that history will repeat itself in terms of overall market trends. Do not try to predict the future, but have risk management strategies in place so that you are ready for any sudden market changes.