Risk management is an important concept in day trading. It is an essential concept because of the significant risks that are involved in the market. It is estimated that most people who start trading lose money.
"Risk Comes from Not Knowing What You're Doing" is a quote from the famous investor Warren Buffett. One of the plethora of lessons every trader can learn from WB, even using a completely different approach than him.
Risk is something that is always involved in the financial markets … but also in the decisions every trader is called upon to make. We want to focus our attention on the latter.
Therefore, in this article, we will look at some of the top risk management strategies to use when day trading.
Trading risks in the market
There are many trading risks in the financial market. In most cases, these risks are divided into systematic and unsystematic risks.
Systemic risks are those that affect the broad financial market. For example, the collapse of Lehman Brothers had systemic risks to the banking sector and other parts of the market.
Similarly, the collapse of FTX and Terra had important systemic risks to the cryptocurrencies industry. Terra’s collapse led to the bankruptcy of companies like Three Arrows Capital and Voyager Digital. Similarly, the collapse of Voyager Digital led to a collapse of other companies.
Some of the other big systemic risks in the market are the Great Depression and the dot com bubble among others. A systemic risk can spread across other financial assets. For example, it can move from commodities to stocks and other assets.
An unsystemic risk, on the other hand, is one that is not broad. It is not shared widely across the wider market.
For example, some of the top unsystematic risks are a liquiditity crunch, labor strikes, and inefficiency of the management. These unsystemic risks are confined to a certain asset.
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Why risk management matters
Risk management is an important concept that refers to the process of reducing risks in the market while maximizing returns.
It looks to keep losses in control and keep your trading capital safe. Without it, you will often find yourself making significant losses and exposing your account to significant risks.
There are several benefits of risk management, including:
- It helps to reduce the amount of losses that you can make per trade.
- It helps to improve your psychological wellbeing.
- A good risk management strategy helps reduce anxiety when trading.
- It can also help you raise capital for your small hedge fund.
Mistakes born from human factor
As we pointed out in the introduction, we do not want to analyze all risk management strategies (we have an article dedicated to this). Here We want to emphasize the mistakes a trader can make by deciding to trade a stock (or another asset) he does not know.
In short, human error.
Let us now look at some of the best risk management strategies that you should use in day trading to avoid this common mistake.
Don't have a trading plan
A trading plan is an essential tool to use when day trading. It refers to a systematic process of identifying and trading securities in the market. The plan will help you make good decisions in the market. A good trading plan should have some key parts.
- Assets to trade - Instead of trading tens of assets, the plan should have a list of assets that you will be trading. Most traders focus on one or two asset classes like stocks or commodities.
- Time to trade - Instead of trading at all time, a good trading plan will help you identify the best times to day trade.
- Trading strategy - A good trading plan will help to define the best strategy to use. As such, you won’t be using multiple strategies in the market.
- Risk management strategies - A good trading plan has provisions for the risk management strategies that you will use to trade.
This advice would be enough to avoid trading blindly by betting on assets you are not familiar with.
Follow the crowd (blindly)
Another approach in risk management is to avoid following the crowd blindly. For starters, following the crowd refers to the process of doing what the other people are doing.
For example, if the market is buying technology stocks or cryptocurrencies, you do the same. Similarly, if market participants are selling stocks, you do the same.
Following the crowd can be a profitable thing to do at times. However, in most cases, you will often find yourself losing money when you follow the crowd blindly.
Instead, you should always work to do research before you execute a trade. Find out the reasons why it is trading the way it is doing and then find a catalyst.
In other words, avoid the Fear of Missing Out (FOMO). FOMO is when people buy what everyone else is buying and vive versa.
Some of the top catalysts you can use in stocks trading are: earnings, merger and acquisition, new product launch, and a new management change.
Trade under emotions
We are all emotional beings. However, to succeed in the market, you need to ensure that you are in a good place emotionally. You will often make trading mistakes when you trade in a stressful period. For example, if you make a big loss, there is a high possibility that you will make another big loss.
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At times, being too happy can lead to substantial losses as well. For example, if you make a big profit, you could assume that the next trades will be that profitable as well.
Therefore, in risk management, always ensure that you have a good emotional balance. In other words, ensure that you don’t let your emotions take control of you.
Trade what you don't know
There are so many assets in the financial market. For example, in stocks, there are thousands of publicly-traded companies. Similarly, there are more than 20,000 cryptocurrencies and tens of commodities.
Therefore, you might find yourself interested in most assets. We recommend that you should only focus on trading assets that you know and those that you have a good understanding about.
For example, if you are a stock trader, focus on a limited number of shares. Similarly, if you are a crypto trader, focus on a small number of them.
In this article, we have looked at some of the best risk management strategy to use when trading. We understood how easy it is to make the mistake of trading something we don't know, and how this can lead to big losses for your portfolio.
Luckily, solutions are simple to apply. We recommend that you use these approaches at all time when trading.
External useful resources
- 7 insights from legendary investor Warren Buffett - CNBC