Risk Management in Stock Trading
There is a scene in the movie Wall Street where Daryl Hannah says “Having had the money and losing it all on the Wall Street is worse than not having had it at all” This sums up the risk associated with investing in the Stock Market. Risk Management is one of the integral parts of investing in the stock market. Some of the key strategies of risk management are:
Splitting the fund into various asset classes. One should never stack the eggs in the same basket .To minimize risk one should split the available money into different classes of assets like fixed deposits, properties, mutual funds etc. Similarly, while investing in stock market one should try to diversify one’s portfolio i.e. put money into different stocks.
Having an astute sense of discipline. A rising stock prices have a prospect of rising more and hence increasing the profits. But there always the perils of the market changing course and the net profit at any moment profit position becoming a loss position. The stock investor should have a discipline in setting targets and adhering to those. For example he could decide something like:
- Sell the stock if the loss exceeds 10 percent i.e. keeping the stop loss at 10 percent.
- Sell 50 percent of the stocks when prices rise 10 percent from the buy price.
- Sell additional 25 percent when the gains become 15 percent.
Greed is one of the main enemies of a stock investor. If an investor sees a stock advancing he adopts a wait and watch strategy to maximize the profits. He finally ends up in making a loss. One has to remember half a penny earned is better than a penny lost.
Proper research of companies in which the investor is intending to invest.Apart from complex technical indicators (RSI, MACD, etc) one must try to analyze the performance by finding answers to some basic information concerning the fundaments of a company(which does not require any expertise into Finance):
- What is the growth rate of the company in comparison to the overall industrial growth rate?
- What is the growth rate of the company vis-à-vis other companies into the same line of business? I.e. whether it is outperforming or underperforming with regard to its competitors.
- What is the performance of the company in the last five years? Whether it has shown a consistent growth record?
- What are the company’s expansion plans?
- Is the company planning to foray into newer markets?
The answer to these basic questions can help the investor in selecting the right companies to invest in. The companies that have given consistent returns over last 5 years and plan to continue the trend by foraying into new markets and constantly expanding are the right companies to invest in.
Hedging by limiting the losses. Hedging is the technique wherein investor tries to protect himself against adverse price movements. This is by simultaneously investing in the cash market and also taking opposite positions in the futures and options market. For example buying 100shares of company A@$40/share. Simultaneously one buys ‘put options’ of strike price 35 at 0.25/option i.e. $25.This means by paying $25 one has secured ones position (to some extend).If the price of stock goes below $25. Hedging would be clearer once the concepts of futures and options are clear.
Thus risk management involves qualitative tools like self restraint discipline and portfolio allocation hedging techniques to alleviate the risk associated with investing in stock markets.
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