Trading carries risks. You know what they say: the high yields are the returns you reap for taking on significant risks. However, you can always manage risks. The best trading platforms will provide you with the information, data, and tools to perform fundamental and technical analyses, and minimise losses.
What can you do to limit your risks? Position sizing and setting up stop-loss orders are the two most basic strategies.
Reading Suggestion: How To Check Unemployment Insurance Fine?
Position Sizing
Position sizing is deciding how many units to procure of a particular security. Your position size determines how much exposure you have on an open position.
To calculate your position size in a way that will limit your risks, start by determining how much of your capital you are willing to risk or lose. One to three per cent is a good range.
If you’ve decided on a risk of 3% and your capital is AED 80,000, that translates to AED 2,400. That’s the amount of capital you may lose if the trade does not go as intended.
After calculating how much of your capital you can afford to lose, assess the specific trade risk. How much loss per share are you willing to take? For instance, suppose you are willing to take an AED 40 loss for every share before exiting a trade. That means limiting your exposure to 60 shares.
That’s the AED 2,400 you can afford to lose divided by the AED 40 risk per share you’re willing to assume, resulting in a position size of 60 units.
Establishing a Stop-Loss Price
Trading platforms typically provide an option to set up stop-loss orders on trades. They’re sell orders triggered when a security attains a particular price.
A stop-loss order will plug up your account and stop it from bleeding capital in case of a downturn. Thus, it’s a crucial risk management strategy. Suppose you buy stock for AED 200 per share and, like the example above, you decide that no more than a loss of AED 40 per share is acceptable.
Now, you can stay glued to your monitor to track stock prices, selling your shares when per-share prices fall to AED 160. The better and more efficient option, however, is to set the stop-loss at AED 160, so stock prices falling to AED 160 will automatically trigger an order to exit your position.
Caveat: Stop-loss orders are activated by threshold price. However, the sale will be executed at the best possible price, which may or may not be the specified stop-loss price.
Stop-loss orders may not prevent a loss greater than your maximum trade risk when the market is acutely volatile. Even if you set a stop-loss price of AED 160, your broker may execute your stop-loss order at a much lower price, say AED 100. The dip in stock prices may be so sudden and extreme – say, a fall from AED 180 to AED 100 – that there was simply no opportunity to sell the security at your threshold price.
In unstable markets, therefore, the best way to mitigate risks to your capital is to monitor your investments manually. There might be a sizable decline in prices that could indicate something is wrong. If you’re on top of your investments, you could decide there and then to exit your position and prevent considerable losses.
Gap Risk
You should also consider gap risk, the risk posed by a great disparity between a security’s closing and opening prices. Gaps are typically driven by news or events happening while the markets are closed, i.e., after trading hours.
In this case, the classic stop-loss order may not be too effective. When the market opens and the price is much lower than the stop-loss price you set, your stop-loss order will automatically be placed even at that much lower price, and you will suffer a considerable loss. Without the stop-loss order, perhaps you could have held on and ridden out the volatility and sold at a better price, thereby minimising your losses.
Types of Stop-Loss Orders
Stop-loss orders can be fixed or trailing.
1- Fixed Stop-Loss Order
A fixed stop-loss order requires you to set a specific stop-loss price. When the security reaches or falls below that fixed price, the order to sell will be activated, and your broker will sell your security.
2- Trailing Stop-Loss Order
A trailing stop-loss order entails setting a stop distance, say 10%, between your purchase price and the sell price. It tracks market movements, so the sell price is always 10% below the peak price. Thus, the trailing stop-loss price only ever goes up, not down.
To illustrate, if you buy at AED 200, the trailing stop-loss price is AED 180. However, if the market price increases to AED 250, the new stop-loss price is AED 225. If the price starts falling, the stop-loss price will not change but remain at AED 225, as trailing stop-loss prices do not move down when the market reverses. Your broker will execute your stop-loss order once share prices fall to AED 225.
Reading Suggestion: Lost Your Licence Plates in Dubai?
Risk Management and Mitigation
While risks are inherent in trading, you can and must manage them to ensure you can limit capital losses. Position sizing and setting up stop-loss orders are two of the most basic risk management strategies.
Talk to your UAE broker to learn more about these and other strategies to mitigate and minimise your risks.
