There are all kinds of different profitable trading strategies, each taking a different approach. Interestingly enough, though, they all share one crucial key component termed Risk Management. A term, which most traders get familiar with at a rather early stage. Either because they are overly sensitive and therefore miss out on great opportunities, or due to being natural risk-takers who have to deal with tremendous losses.
This imbalance between sensitivity and risk-taking propensity once again depicts that the art of trading stocks and human emotions do not interact well together. The goal therefore has to be to define a set of rules which counterbalance these extremes for us without our emotional involvement.
What Does Good Risk Management Entail?
The first prominent question that we have to ask ourselves is: What exactly does good risk management entail? Let’s kick things off by having a look at an actual definition of the term:
In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.— Investopedia
According to this definition, risk management comprises the tasks of identification, analysis, mitigation and acceptance of the risk. In order to better understand these terms, we will assign essential guidelines for traders to every single one of these.
Everything surrounding risk management is rooted in the identification of the actual sources of risk. We all know that trading stocks entails risk but what are actual sources of risk that we as traders can identify and manage?
News – Never Anticipate the Resulting Effect
While the resulting effect of a recent news is a sound trading opportunity, the anticipation of said effect is not. It is therefore essential to always stay up-to-date with upcoming announcements and not to trade affected tickers beforehand. As news can sometimes be released unexpectedly, you as a trader should at all times be ready to exit an open position. Examples of scheduled news would be earnings releases and statements of the Federal Open Market Committee (FOMC).
Volume – Make Sure You Can Always Get Out
In order to be able to exit your positions at a predetermined price level, for profit or loss, you have to make sure that the required liquidity is present at all times. The more shares you trade, the more important this source of risk becomes. There is nothing worse than being stuck in a major loss or having to exit a profitable position for a loss, just because there is no-one around to fill your order. As a rule of thumb, a minimum daily volume ranging from three to five million is sufficient to always get in and out of a trade whenever you like.
Float – When the Float is Low, the Risk is High
Due to the simple laws of supply and demand, another fundamental source of risk is the amount of floating stock. Before digging deeper, let’s once again look at a definition of the term at hand:
The number of shares available for trading of a particular stock. Floating stock is calculated by subtracting closely-held shares and restricted stock from a firm’s total outstanding shares.— Investopedia
Whenever a notable shortfall of floating stock in contrast to the current volume arises, volatile price movements and squeezes are on the agenda. This is often the case for stocks of companies with a small market capitalization which currently attract a vast audience. As there is not a big enough supply of shares, the price increases and decreases rapidly, making it hard to get in and out of a position quickly. Consequently, it is wise to enter such a trade with a smaller amount of shares than you would normally trade or to avoid such tickers all together.
Spread – Wide Spread Indicates Uncertainty
A significantly higher ask price compared to the highest bid price generally indicates uncertainty among the audience currently trading the stock. The most frequent catalysts for a wide spread are missing liquidity and volatile price movements.
Usually, a market move with plenty volume can be rated more significant than other price changes. Thus, illiquid movements advancing on wide spread should be treated carefully when analyzing a chart.
Volatile price changes can be triggered by a multitude of reasons. Sudden volatility caused by uncertainty due to catalysts such as news, often brings along a wide bid-ask spread. Therefore, it is imperative to make a fair assessment, whether or not your personal risk levels are significant enough compared to the fast market moves.
Risk to Reward Ratio – Lose Small, Win Big
The principle, only to trade setups whose potential reward is bigger than their potential loss, can be the decisive difference between a subpar and outstanding trading strategy. When assessing, whether or not a particular trade is reasonable, you should always make a comparison between the range to your hard stop and the range a stock can go in your favor. Customarily, it is prudent only to trade setups which can run at least twice as far on your behalf than they can move against you. As a result, you can be tremendously successful even with a poor win to loss ratio.
Summary – Part I
The goal of a meaningful risk management has to be to define a set of rules which counterbalance the sensitivity and risk-taking propensity of a trader. This can be done by identifying, analyzing, mitigating and accepting risk. In a first step, we identified the following sources of risk which should be carefully assessed before entering a trade:
- News – Stay up-to-date with upcoming announcements and do not anticipate said resulting effect.
- Volume – As a rule of thumb, only trade stocks with a minimum daily volume ranging from three to five million.
- Float – Be aware of the increased risk when trading tickers with a small amount of floating stock. Especially when dealing with stocks of companies with a small market capitalization.
- Spread – Customarily, stay away from stocks with a notable bid-ask spread as it usually projects uncertainty.
- Risk to Reward Ratio – Only trade setups with a risk to reward ratio better than 1:2.
Part 2 - Coming Soon