Risk Management

Risk Management

With some broker accounts, leveraging can greatly amplify returns as well as losses. If your $1000 account is invested in a stock with a 75% leverage ratio, giving you $4000 worth of shares, a 25% fall in the stock price will mean you lose your whole $1000. Any further falls will result in you owing the broker money. It’s a high risk game. A quick tip is to divide 1 by the % that you contribute (e.g. 25% as above), which gives you 4. Any movement in the stock price (e.g. 10%) is amplified 4 times (now 40%) when it comes to working out your return on capital.

Risk Management Tip 1 – Leverage Ratio

The most important thing, before profits, is risk management. First decide on how much you are willing to lose (say $1000) and what % of your account this is (say 25%). With no leveraging, you could invest all of your $4000, and stop once you have lost 25%, or $1000. With a margin loan (75% leverage ratio), you would still have an investment of $4000, but you would have used just $1000 of your money and the remaining $3000 would be sitting in cash in the trading account. The same applies to higher leverage ratios (e.g. forex trading), and this technique ensures that you never invest more than you were initially prepared to lose. Never use $1000 at a 75% leverage ratio ($4000 investment), and then the same amount on foreign exchange with a 99.5% leverage ratio ($200,000 investment), as this is when the losses spiral out of control. This technique means you could use your account as if there was no leveraging (keep a lot left in cash), but take advantage of the ability to short sell and trade a wider variety of assets with an online cfd trading account.

Risk Management Tip 2 – Stop Loss Order

All orders should be accompanied by a ‘stop loss order’, meaning they are exited once a certain loss is incurred. Decide what the maximum you are prepared to lose is, and if the stop is hit, don’t put the position on again. Trust you were wrong, not the market, and move on. Whilst a stop loss can protect you from price movement during the trading day, it cannot protect you from ‘gap risk’, which is the risk of prices moving in the wrong direction when the market (in particular stock market) opens the next day. A big move in overseas markets can mean it opens down 1%+, so any standard stop loss closes the position at the open (1% fall), even if you wanted to stop the trade after a 0.25% fall (the market skipped the 0.25% fall and jumped straight to a 1% fall, meaning the broker gave you the best price they could, being a 1% fall). You have now incurred a loss four times larger than you planned, and the only way to avoid this is a guaranteed stop loss order.

Risk Management Tip 3 – Guaranteed Stop Loss Order

A guaranteed stop costs more to use, but should be considered when you expect an asset to become volatile, and where the market is not open for a portion of the day (i.e. stock market). When you specify your maximum loss level, you are guaranteed that by the broker, so even if the market opens 1% lower, you lose 0.25% and the broker bears the other 0.75%. It is their job to hedge their books, and to offset this loss with the fee you pay for using a guaranteed stop loss. This type of order is more useful for short term traders rather than longer term investors, but should be a part of every market participant’s arsenal

These two types of stop loss orders should always be used to prevent the losses exceeding those that you are prepared for, and are essential for successful trading and investing.

In the pipeline: How to use stops to increase profits

Bullish on: Gold stocks (underpriced relative to gold’s value, price suggests gold is at $1000 not $1600, will correct quickly when market rallies)

Bearish on: Telstra (TLS – approaching broker price targets, could fall over the next 6 months as TLS is sold to fund riskier assets), US 10yr T-Notes (yields supported by good US data in the short term, 1-2 week short trade or be prepared to ride out volatility and hold short throughout 2012 if markets rise) 

Please let me know your thoughts, and any questions/topics you would like me to discuss.