Understanding Trading Risk Management Essentials Articles | Risk Management

By: Stu McPhee and David Jenyns

The question one needs to consider before trading is this... Are you prepared to lose your entire trading capital or will you stop if you lose 50% of your capital having convinced yourself that your approach is not working for you? This is obviously a situation that you do not wish to consider but is important to prepare yourself mentally for this possibility.

A popular way of violating your primary aim in your trading (which is to preserve your capital) is to commit a large amount of money into one share purchase hoping that it goes up, even if it takes a while. To make the situation worse, you then proceed to not cut your loss once it has headed in the wrong direction for an extended period. There have been many shares that have taken long downward runs and have never returned to previous highs and potentially never will.

There are many examples in recent times in Australia of this very situation which verify the necessity for trading risk management consideration. For example, look what happened to HIH Insurance which was at one stage trading at close to $4 and now does not exist. Shareholders were left with essentially nothing of their initial investment.

Consider what happened to One.Tel which was at one stage trading at over $2.50 after a 10 for 1 share split and less than two years later, ceased to exist. Again, shareholders were left with essentially nothing of their initial investment.

These companies are not unique. There has even been some blue chip companies that are presently well below their previous highs and are taking their time in getting back there, with of course no guarantee that they will.

Capital preservation is a critical part of trading risk management. Risk is dealt with differently by different people. Usually when faced with a trade that is at a loss, disciplined traders become risk averse and are quick to sell the shares with a small loss. Most traders usually become risk seeking as they hold on and wait for the share price to return to near their entry price. This shatters one of the time tested trading rules of 'cutting your losses'.

When disciplined traders are faced with a profitable trade, they become risk seeking, and do not exit the trade prematurely. They want to hold out from closing the position for as long as possible to see how far the share price increases. Most traders when faced with a similar situation, become risk averse as they are quick to sell their shares to realise a small profit with the fear of losing it all. Notice how the acceptance of risk is completely different between the disciplined traders and most traders in the market. The reactions of most traders are completely natural, however.

The difference between traders that are able to apply trading risk management principles and abide by them and those that aren't is paramount. Successful and disciplined traders have overcome their natural tendencies and exercise great internal control. Capital preservation is essential for trading success.