A Quick Guide to Risk Management in Investing and Trading
Two magical words that can help traders and investors survive during volatile market conditions is risk management. Risk management protects traders from losing money and helps them stay in the game for a long time. In this article, we will go into detail about risk management and explain time-tested rules to make sure you don’t lose money.
Risk management in investing
There are two main types of risk management for investors and for traders. Trading and investing are a bit different but similar rules can be applied with slight differences. When investing you are buying an asset for the long term and waiting for its price to increase. Imagine Warren Buffet and how he managed to buy and hold stocks for decades. That’s an investment father right there. The most robust and tested method every investor should apply in their practice is portfolio diversification. Don’t put all the eggs in one basket is a famous quote that works in investing.
Every sector has its advantages and disadvantages and when buying stocks only from one sector there is a chance that the sector goes down and your stocks will follow. So the best course of action is to buy stocks from different sectors and fields. Like Tesla is a car company, if you buy Tesla shares try not to buy too many shares from car manufacturers. Buy other companies’ stocks like google, apple. Diversify your portfolio so that no matter what happens in the markets there is always one winning sector or sector that was stable during the recession. We will speak more about the 2023 recession below.
Risk management in trading
Trading is different from investing as it is more focused on short-term returns. Portfolio diversification is good here too. But the main challenge is to limit losses and not drain trading account balance too quickly so that it becomes hard to regain lost capital. There are a few important risk-limiting steps to take here
Stop loss in trading is more important than a safety belt while driving! Yes, you heard this correctly, trading without stop loss guarantees that you blow up your account in the long term, often in a few months or even weeks. When trading, stop loss and take profit are probably two staples for your survival. The stop loss and take profit orders are order types, actually. Always place a stop-loss order whenever you have an open trade. No matter what.
The 2% rule
Don’t risk more than 2% of your account on any single trade. If you have multiple trades try not to risk more than 2-4% of your capital in all of them combined. This is crucial, it can help you survive. Many traders lose their money too often and can’t continue trading because they have no capital left and they lose motivation. Staying in the game long-term is the main challenge in trading. This long-term approach is very popular in the case of businesses as well. If your business manages to survive for more than 10 years let’s say. Is it not a sign of success? You can stay in trading for years if you manage your risks wisely. Place stop loss and don’t risk more than 1-2% of your capital ideally on any trade or trades.
Risk to reward Ratio
The third most important factor is to make more profit than you risk. Especially for day traders and swing traders who have trades opened for days. It is very important that your risk-to-reward ratio stays between 2 and 3. This will make sure that commissions and swaps don’t eat up most of the profits.
How to manage risks in the 2023 recession
The recession is coming in 2023. It is all confirmed by professionals and market experts. This is caused mainly by the war in Ukraine and post-covid inflation. But the main reason is the Fed’s policy to increase interest rates until inflation gets around 7%. This will cause the economy to slow down and GDP to decline. Because of this, there will be a plethora of blown-up companies. It has already started with FTX, Carvana, and others going bust.
During this time risk management becomes even more important and more conservative approaches must be taken. Traders have an advantage here, they can make money even when markets are falling by short-selling the assets. It is possible that 2023 will be a good year for traders despite the recession. This can be the opposite for hedge funds and other big trading companies, that hold many stocks and various assets, as they will struggle to close their positions in profits because of selling pressure.
Managing risks is key in trading and investing. Especially careful measures must be taken during 2023 because of the high probability of recession. Always risk less than 2% of your account balance, make sure you have a stop loss in place, and try not to have a risk-to-reward ratio less than 1:1.5. These steps will make sure you survive in the long term which is the most important thing in trading and investing.