New investors in the stock market are often so enthused by the riches and wealth that await them that they fail to address the most important aspect of stock market involvement.
There is no denying that share trading and investing carries substantial risk, and this risk must be mitigated. Protecting the investors’ capital is paramount, and the markets should be approached with a plan in place to prevent a catastrophic blow wiping out the account.
Ways to Manage Risk in a Stock Share Portfolio- Position Sizing to Minimise Risk
Position sizing is a simple technique that ensures that no position in the stock market uses more than a set percentage of the portfolios' overall capital.
There are various ways to determine an appropriate position size:
- Equal portions – This involves dividing the total capital base into equal amounts using either fixed dollar portions or a fixed percentage of capital. Doing this ensures that the capital is to some extent protected in the event one of the investments collapses.
- Percentage of Capital - This is implemented by a defining a set percentage of capital to be risked on each trade or investment – for example 2%. Once the stock or share price drops and wipes out 2% of the investors capital, the trade is closed out and a relatively small loss is realised. This strategy ensures no more than 2% of the total capital will be lost on any position. In theory this means 50 losses would be required to wipe out the account entirely.
These two strategies also combine effectively to further reduce risk.
Reducing Risk Through the Diversification of Markets
Often investors are convinced they are diversified when in fact they aren’t. Diversification is commonly regarded as holding investments in different stock market sectors whereas in reality all the sectors are largely correlated and therefore only provide a limited amount of risk mitigation.
It is far more effective to spread a portfolio across different markets entirely. A hypothetical example of balanced portfolio could incorporate the AUD/USD, Corn Futures, Crude Oil, Silver and the S&P500 Index. These markets do not travel together and provide true diversity in a portfolio.
Use Automatic Stop Loss Orders to Limit Risk and Protect Capital
More and more brokerages are now offering stop loss orders for shares and other instruments. A stop loss is an order that is put into the market at a set price and automatically triggered when the share price falls to that level. For example if an investor wanted to cut his loss short when his stock dropped to $5.00, he would enter in his order and, should the price fall it would be triggered and his shares sold.
This allows the investor to rest easy knowing that his capital is protected and also means that he doesn’t need to constantly monitor the market to see what is happening.
Managing Investment Risk by Hedging Stock Market Positions
Hedging a position is quite an expensive way to protect against adverse moves in a stock; however it is commonly used and can be effective.
Buying put options is a commonly used method of hedging a position. Put options are an instrument that gives the owner the right, but not the obligation to sell a parcel of shares at a predetermined (‘strike’) price.
For this privilege the investor will pay a premium, and it works in a similar way to an insurance policy. If the share doesn’t drop below the strike price within a given timeframe, the investor loses the premium paid. However in the event the share price does drop through the strike the investor may either sell his shares at that price, or on-sell the option at a profit, thereby offsetting the unrealised loss on his position.
To read more about stocks, trading and risk management please have a look at the following -
Choosing a Trading Course in Forex, Stock or Options Trading
Stock Market Investing – Position Sizing to Minimise Trading Risk
Learn How to Verify Hot Stock Tips and Free Stock Trading Advice
Trading Risk Management - Setting a Stop Loss to Minimise Risk
Jessica Peletier - Jessica Peletier is a woman of varied interests. She is private investor with experience trading shares, CFD's and options, as well as ...
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