Risk Management Techniques for Active Traders (2024)

Risk management helps cut down losses. It can also help protect traders' accounts from losing all of its money. The risk occurs when traders suffer losses. If the risk can be managed, traders can open themselves up to making money in the market.

It is an essential but often overlooked prerequisite to successful active trading. After all, a trader who has generated substantial profits can lose it all in just one or two bad trades without a proper risk management strategy. So how do you develop the best techniques to curb the risks of the market?

This article will discuss some simple strategies that can be used to protect your trading profits.

Key Takeaways

  • Trading can be exciting and even profitable if you are able to stay focused, do due diligence, and keep emotions at bay.
  • Still, the best traders need to incorporate risk management practices to prevent losses from getting out of control.
  • Having a strategic and objective approach to cutting losses through stop orders, profit taking, and protective puts is a smart way to stay in the game.

Planning Your Trades

As Chinese military general Sun Tzu's famously said: "Every battle is won before it is fought." This phrase implies that planning and strategy—not the battles—win wars. Similarly, successful traderscommonly quote the phrase: "Plan the trade and trade the plan." Just like in war, planning ahead can often mean the difference between success and failure.

First, make sure your broker is right for frequent trading. Some brokers cater to customers who trade infrequently. They charge high commissions and don't offer the right analytical tools for active traders.

Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan ahead when trading. Successful traders know what price they are willing to pay and at what price they are willing to sell. They can then measure the resulting returns against the probability of the stock hitting their goals. If the adjusted return is high enough, they execute the trade.

Conversely, unsuccessful traders often enter a trade without having any idea of the points at which they will sell at a profit or a loss. Like gamblers on a lucky—or unlucky—streak, emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits can entice traders to imprudently hold on for even more gains.

Consider the One-Percent Rule

A lot of day traders follow what's called the one-percent rule. Basically, this rule of thumb suggests that you should never put more than 1% of your capital or your trading account into a single trade. So if you have $10,000 in your trading account, your position in any given instrument shouldn't be more than $100.

This strategy is common for traders who have accounts of less than $100,000—some even go as high as 2% if they can afford it. Many traders whose accounts have higher balances may choose to go with a lower percentage. That's because as the size of your account increases, so too does the position. The best way to keep your losses in check is to keep the rule below 2%—any more and you'll be risking a substantial amount of your trading account.

Setting Stop-Loss and Take-Profit Points

A stop-loss point is the price at which a trader will sell a stock and take a loss on the trade. This often happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the "it will come back" mentality and limit losses before they escalate. For example, if a stock breaks below a key support level, traders often sell as soon as possible.

On the other hand, a take-profit point is the price at which a trader will sell a stock and take a profit on the trade. This is when the additional upside is limited given the risks. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation takes place.

How to More Effectively Set Stop-Loss Points

Setting stop-loss and take-profit points is often done using technical analysis, but fundamental analysis can also play a key role in timing. For example, if a trader is holding a stock ahead of earnings as excitement builds, they may want to sell before the news hits the market if expectations have become too high, regardless of whether the take-profit price has been hit.

Moving averages represent the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the 5-, 9-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a stock's chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.

Another great way to place stop-loss or take-profit levels is on support or resistance trend lines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. The key is determining levels at which the price reacts to the trend lines or moving averagesand, of course, onhigh volume.

When setting these points, here are some key considerations:

  • Use longer-term moving averages for more volatile stocks to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
  • Adjust the moving averages to match target price ranges. For example, longer targets should use larger moving averages to reduce the number of signals generated.
  • Stop losses should not be closer than 1.5 times the current high-to-low range (volatility), as it is likely to get executed without reason.
  • Adjust the stop loss according to the market's volatility. If the stock price isn't moving too much, then the stop-loss points can be tightened.
  • Use known fundamental events such as earnings releases, as key time periods to be in or out of a trade as volatility and uncertainty can rise.

Calculating Expected Return

Setting stop-loss and take-profit points are also necessary to calculate the expected return. The importance of this calculation cannot be overstated, as it forces traders to think through their trades and rationalize them. It also gives them a systematic way to compare various trades and select only the most profitable ones.

This can be calculated using the following formula:

[(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)]

The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade. The probability of gain or loss can be calculated by using historical breakouts and breakdowns from the support or resistance levels—or for experienced traders, by making an educated guess.

Diversify and Hedge

Making sure you make the most of your trading means never putting all your eggs in one basket. If you put all your money into one idea, you're setting yourself up for a big loss.Remember to diversify your investments—across both industry sector as well as market capitalization and geographic region. Not only does this help you manage your risk, but it also opens you up to more opportunities.

You may also find yourself needing to hedge your position. Consider a stock position when the results are due. You may consider taking the opposite position through options, which can help protect your position. When trading activity subsides, you can then unwind the hedge.

Downside Put Options

If you are approved for options trading, buying a downside put option, sometimes known as a protective put, can also be used as a hedge to stem losses from a trade that turns sour. A put option gives you the right, but not the obligation, to sell the underlying stock at a specified priced at or before the option expires. Therefore, if you own XYZ stock for $100 and buy the six-month $80 put for $1.00 per option in premium, then you will be effectively stopped out from any price drop below $79 ($80 strike minus the $1 premium paid).

What Is Active Trading?

Active trading means regularly attempting to take advantage of short-term price fluctuations. You’re not buying stocks for retirement. The goal is to hold them for a limited amount of time and try to profit from the trend. Active traders are named as such because are frequently in and out of the market.

What Are the Risk Management Techniques Used by Active Traders?

Techniques that active traders use to manage risk include finding the right broker, thinking before acting, setting stop-loss and take-profit points, spreading bets, diversifying, and hedging.

What Is the 1% Rule in Trading?

The 1% rule demands that traders never risk more than 1% of their total account value on a single trade. In a $10,000 account, that doesn’t mean you can only invest $100. It means you shouldn’t lose more than $100 on a single trade.

How Do I Become a Successful Active Trader?

To become a successful active trader you must understand financial markets and be familiar with the various tools used to read price movements. You must also have sufficient capital and time to trade and be capable of keeping your emotions in check. The key is having a strategy and sticking to it. And, if you want to be successful over the long term, spreading out your bets.

Active trading isn’t for everyone. Despite what you may hear, it isn’t easy and guaranteed to generate enough money for you to quit your day job. Think carefully, start small, and try simulating some trades on a test account before putting your money on the line.

The Bottom Line

Traders should always know when they plan to enter or exit a trade before they execute. By using stop losses effectively, a trader can minimize not only losses but also the number of times a trade is exited needlessly. In conclusion, make your battle plan ahead of time and keep a journal of your wins and losses.

Risk Management Techniques for Active Traders (2024)

FAQs

Risk Management Techniques for Active Traders? ›

Techniques that active traders use to manage risk include finding the right broker, thinking before acting, setting stop-loss and take-profit points, spreading bets, diversifying, and hedging.

What is the 3 5 7 rule in trading? ›

What is the 3 5 7 rule in trading? A risk management principle known as the “3-5-7” rule in trading advises diversifying one's financial holdings to reduce risk. The 3% rule states that you should never risk more than 3% of your whole trading capital on a single deal.

What is the risk management of traders? ›

A proper risk-management strategy is necessary to protect traders from catastrophic losses. This means determining your risk appetite, knowing your risk-reward ratio on every trade, and taking steps to protect yourself from a long-tail risk or black swan event.

What are the 4 strategies for risk management? ›

There are four common risk mitigation strategies: avoidance, reduction, transference, and acceptance.

What strategies do you use to evaluate risk in trading? ›

In trading, various strategies are used to manage risks. These include passive methods like diversifying portfolios and investing in stable sectors, as well as active approaches like trading based on market developments, using stop loss orders, and hedging with derivatives.

What is 90% rule in trading? ›

The 90 rule in Forex is a commonly cited statistic that states that 90% of Forex traders lose 90% of their money in the first 90 days. This is a sobering statistic, but it is important to understand why it is true and how to avoid falling into the same trap.

What is the 80 20 rule in trading? ›

In investing, the 80-20 rule generally holds that 20% of the holdings in a portfolio are responsible for 80% of the portfolio's growth. On the flip side, 20% of a portfolio's holdings could be responsible for 80% of its losses.

What is No 1 rule of trading? ›

Rule 1: Always Use a Trading Plan

You need a trading plan because it can assist you with making coherent trading decisions and define the boundaries of your optimal trade. A decent trading plan will assist you with avoiding making passionate decisions without giving it much thought.

What is the 1 percent rule in trading? ›

The 1% rule demands that traders never risk more than 1% of their total account value on a single trade. In a $10,000 account, that doesn't mean you can only invest $100. It means you shouldn't lose more than $100 on a single trade.

What is the 1% risk rule? ›

The 1% risk rule means not risking more than 1% of account capital on a single trade. It doesn't mean only putting 1% of your capital into a trade. Put as much capital as you wish, but if the trade is losing more than 1% of your total capital, close the position.

What are the 5 principles of risk management? ›

The 5 basic principles of risk management are to: Avoid risk - Identify appropriate strategies that can be used to avoid the risk whenever possible, if a risk cannot be eliminated then it must be managed Identify risk - Assess the risk, identify the nature of the risk and who is involved Analyse risk - By examining how ...

What are the three 3 approaches to risk management? ›

It involves the process of identifying, assessing, and prioritizing risks, as well as developing and implementing strategies to mitigate or minimize those risks. There are three main types of risk management: financial risk management, operational risk management, and strategic risk management.

What is the final step in risk management? ›

The final step is to document the strategy to ensure that all the planned measures are implemented as intended. But the work doesn't end there. Risk management is a continuous process, especially since the risk landscape is constantly changing.

How do you control losses in trading? ›

Tips to Reduce Trading Loss
  1. Set Stop Loss. Stop loss is a risk mitigation strategy traders use to limit possible losses on a trade. ...
  2. Focus on Diversification. ...
  3. Use Stop-Loss Adjustments. ...
  4. Avoid Overtrading. ...
  5. Stay Informed About Market News. ...
  6. Avoid Whipsaws. ...
  7. Practice Risk Management. ...
  8. Use Indicators.
Jul 31, 2023

How do you master risk management? ›

Five common strategies for managing risk are avoidance, retention, transferring, sharing, and loss reduction. Each technique aims to address and reduce risk while understanding that risk is impossible to eliminate completely.

How do you overcome trading losses? ›

How to Recover From a Big Trading Loss
  1. Learn from your mistakes. Traders need to be able to recognize their strengths and weaknesses—and plan around them. ...
  2. Keep a trade log. ...
  3. Write it off. ...
  4. Slowly start to rebuild. ...
  5. Scale up and scale down. ...
  6. Use limit and stop orders.

What is the 60 30 10 rule in trading? ›

This reinventive basic rule to portfolio structure means allocating 60% to equities, 30% to bonds, and 10% to alternatives. The exact percentages may vary by portfolio, but the key idea is that Alternatives should be an integral part of every portfolio, in some percentage.

What is the golden rule of traders? ›

Let profits run and cut losses short Stop losses should never be moved away from the market. Be disciplined with yourself, when your stop loss level is touched, get out. If a trade is proving profitable, don't be afraid to track the market.

What is the 3 30 rule in trading? ›

This rule suggests that a stock's price tends to move in cycles, with the first 3 days after a major event often showing the most significant price change. Then, there's usually a period of around 30 days where the stock's price stabilizes or corrects before potentially starting a new cycle [1].

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