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What are Shares?
Boasting a long and colourful history, trading in shares remains popular among retail traders and investors.
Often referred to as stocks or equity, shares represent units of ownership within a company. Dividend payments are common with some companies, a method of sharing company profits with shareholders.
In addition to traditional share dealing, however, traders can access derivatives: trading instruments derived from the movement of an underlying stock price.
Individual stock CFDs (contract for differences) fall under the umbrella of derivative products, an effective low-cost trading vehicle. While CFDs do not grant shareholder privileges, active CFD positions may receive a dividend if executed before the ex-dividend date.
Share Trading Risks
Risk in trading is defined as potential failure to deliver an expected return.
Regardless of the asset class traded—stocks (stock market), foreign exchange (Forex), bonds (think government and corporate bonds), or commodities—overseeing risk is an integral aspect of a trading plan.
There has never been a trading system—be it a discretionary system, a nondiscretionary system or a partial discretionary system—that provided 100 percent profitability, despite sophisticated mathematics and theories. Losses are inevitable in trading.
Risk-management practices, therefore, cannot be underestimated. You may be a phenomenal analyst, yet void of a risk-management approach, your trading career is likely to be short-lived.
‘If you fail to plan, you are planning to fail’ ― Benjamin Franklin
A trading plan is a road map, a framework designed to streamline the trading process. Having a trading plan is a trader’s first step to mitigating trading risk.
Key features Included within a trading plan are trading strategies employed, money-management systems, risk-management strategies, a trading journal and market selection.
Working with a trading plan helps maintain an objective mindset, strengthens trading discipline and defines trading goals.
Trading with a Protective Stop-Loss Order
As its name implies, a protective stop-loss order is in place to protect you—the trader—from excessive loss. This is a vital component of any risk-management approach, serving to preserve a trader’s equity. It is surprising how many traders fail to use protective stop-loss orders.
In some cases, traders adopt mental stops. Unlike a hard stop (described above), a soft stop is a pre-defined level the trader manually liquidates a position. The danger, of course, is not having sufficient emotional discipline to exit the market at the level.
Furthermore, in rapid markets, a stock’s price can move within seconds. While with a hard stop the trader may experience slippage, the account fluctuations inflicted on a trading account could be drastically worse in the case of a soft stop.
Protective stop-loss orders are a MUST to help mitigate risk.
Risk Per Trade
Determining risk tolerance for each trade is an important decision. 2 percent of account equity on a single trade is recognised as a general rule of thumb. However, the decision is trader dependent.
A short-term day trader (day trading)—those who can take on multiple positions during a trading session—may be uneasy risking 2 percent each trade. 3 trades, for example, represents 6 percent equity risk. In this case, risking 0.5 or 1 percent is likely more fitting.
On the other hand, a long-term position trader—those focusing on broader market moves—may be comfortable risking 3 percent on each trade, as he or she could take less than 10 trades each year.
To help manage risk, a rule some traders follow is employing a cut-off point: a process devised to pause trading activity if drawdown reaches a specific level.
Some are comfortable with an account drawdown of 10 percent; others would consider 10 percent unbearable.
The point is to have a level, a drawdown value, where the trader essentially says enough is enough. The value should be outside the trading system’s regular drawdown settings. For example, if the back test revealed maximum drawdown was 8 percent, setting the maximum drawdown limit to 12 percent is an option, as then the trader understands trading activity is outside standard thresholds.
Having a cut-off point enables a trader to step back and reassess.
Additional Risk-Management Factors:
Detailing each risk parameter is beyond the scope of this article.
Below lists some additional risk-management aspects traders must employ to help mitigate the risks of shares trading:
- Risk-Reward Ratio
Risk-reward ratio measures the difference between risk (amount risked on one trade) and targets (take-profit target). The majority of traders target at least 1.5 times the risk on a trade.
- Leverage and Margin
Leverage and margin are related concepts. The higher the leverage on an account (this is fixed), the lower the margin requirement (initial margin). Conversely, lower leverage means higher initial margin.
- Position Size
Position sizing involves determining the number of CFD contracts invested in a particular CFD product.
To select position size, entry and stop levels must be determined.
Irrespective of the financial market traded, traders are risk managers. Mitigating risk is priority.
While the article has not touched on all risk factors to consider when trading shares, it should help provide a foundation to develop knowledge surrounding risk management.
Key takeaway points:
- Understand your market; understand the different ways in which shares are traded.
- Trade with a plan.
- Employ protective stop-loss orders.
- Consider implementing a drawdown cut-off point.
- Define and respect risk per trade.