Basic Considerations For Risk Management
For share traders, risk management is defined as limiting the losses oneâ€™s trading account can suffer. It requires organisation of oneâ€™s trades in such a way that the risk of catastrophic loss is minimised and the possibility of suffering smaller losses is spread over several trading categories, so that more than one isnâ€™t likely to occur at the same time. Specifically, this includes:
- holding more than one position,
- in more than one industry sector,
- with positions being both long and short,
- in companies of various sizes,
- and with no single position dominating oneâ€™s capital.
Most of this is common sense. While there may be trading opportunities so outstanding that the trader is tempted to put all his capital into that single position, native prudence is likely to warn him, even in the heat of the moment, to hold some capital in reserve (diversification into more than one position). As well, the trader who holds only homebuilding stocks would suffer a rude shock should the bottom fall from the market, as happened in 2007â€“2008 in the United States (diversification into more than one industry sector).
However, at this point it becomes a bit more complex. For example, many share traders donâ€™t consider limiting their risk by holding small-cap and medium-cap stocks as well as large-cap, blue chip stocks (diversification by company size). However, the 2009 rally began at the smaller end of the ASX, with some of the larger companies not bottoming out and reversing until the small-caps and mid-caps had the rally well underway. A trader who limited his portfolio to large-caps would have been left at the starting gate.
Holding both long and short positions (diversification by position type) as a matter of risk management is also often overlooked. It does seem contraindicated to open a short position in a bull market, or a long position when the bears are rampaging. However, markets can turn on a dime (and give change), and woe betide the trader not holding at least several opposing positions when that happens. But for the trader with both long and short positions in the portfolio, profits are likely whether the current trend continues or otherwise.
Finally, share traders can limit their losses by allocating only a certain percentage of their trading capital to a single position (risk management through position sizing). This can be done either arbitrarily, through not committing more than 5% (for example) to any single position, or by assigning a trader-defined level of risk to each position during the assessment phase. Less risky positions can be allocated a greater proportion of available capital, while positions with an inherently greater level of risk can be allocated less.
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