Do you blindly follow the mantra- Higher the Risk, Higher the return? In doing so, you might lose a major chunk of your wealth creation. Instead, you can play smart and adopt risk management strategies in the stock market to make better investment decisions. The stock market can be a great source of wealth creation if you take calculated risks and make smart decisions.
Not taking risks one doesn’t understand is often the best form of risk management.”― Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy
What is meant by risk management?
Risk management is a process of identifying and assessing the risks and taking necessary measures to protect yourself from the risk. It focuses on strategies to mitigate and manage the risk. For once, consider risk as coin. Reward is one side of the coin whereas Loss is the other side of the coin. People often ignore the loss side and don’t understand the importance of risk management in stock market.
Now, let us understand what are the risk management strategies you can adopt in the stock market while trading.
Risk Management in Stock Market
Follow the stock market trend
Many investors believe that trading against market trends will yield great returns. However, this is one of the common mistakes made by the investors. Following the stock market trend is one of the risk management strategies which helps you to decide whether you should invest or not. The candlestick pattern is one of the most effective tools to identify the trends in the stock market. Hence, it helps you to make buy or sell decisions following the prevailing stock market trend.
Diversification in the portfolio
The diversification in the portfolio means you make investments in two or more key financial instruments in the stock market. Further, you can diversify your investments in the stock market in different sectors. The diversified portfolio protects you from the market fluctuations in a specific sector or the specific company. As a result, if one investment fails, the performance of other investments balances the returns.
Determine stop loss level & take profit level
The successful traders commonly quote the phrase: “Plan the trade and trade the plan”. You should assess the risk-taking capacity and determine open and close position. Let us understand what is stop loss and take profit level.
Stop loss is the lowest point at which the investor is targeting to prevent further loss. It helps you to minimize your loss when the stocks are nearing the support levels.
While, Take profit is the highest price level at which the investor is willing to sell and book profits. It helps to book profits as stocks are racing toward resistance levels and are going to decrease after it.
One percent rule
The one percent rule suggests that you should never put more than 1% of your capital in trading account in a single trade. For example, if you have Rs. 10000 in your account, you shouldn’t invest more than 100 in one trade. It is a common rule which many traders follow while trading who have an account of less than Rs.100000. If you have more capital you can go up to 2% and not more than that to prevent substantial losses.
Assess your risk taking capacity
You should assess your income sources and determine an amount which you feel you can invest per day or month. Follow 50-20-30 financial thumb rule to determine the amount which you should ideally invest. Read more.
The stock market is unpredictable and you might end up loosing all your wealth due to one wrong trade. Thus, risk management in stock market is important to save you from losses and make profitable trades.
Importance of risk management in trading
The risk management in stock trading is important because:
- It protects from potential heavy losses in future
- It helps you to take calculated risks.
- You know your risk-taking capacity so you plan your finances accordingly.
- It helps you to determine entry and exit points.
- It helps you to make better and profitable investment decisions.
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