Risk management is a very important component of trading which can impact one's overall trading performance over time. It is possible for a trader who has generated substantial profits over his or her trading lifetime to lose it all in just one or two bad trades if proper risk & capital management is not applied when placing a trade.
Planning a trade or investment, specifying your entry point, exit point, and the percentage of capital to be put at risk can be the difference between success and failure over the long-run. Successful traders know what price they are willing to Buy an asset and at what price they are willing to Sell. They also have a pre-defined exit point should the market move against them for whatever reason. Most traders who are unsuccessful often enter a trade without having any idea of the points at which they will exit at a profit or a loss.
Like gamblers on a lucky or unlucky streak, emotions begin to take over and dictate their trades. Losses often lead people to over-trade and take even greater risks with the hope of making their money back.
Stop-Loss and Take-Profit Points
A stop-loss point is the price at which a trader will exit a position on a stock or other other financial instrument and take a loss on the trade when the market moves against them. These exit points are designed to limit losses to small amounts before they escalate to trading capital crippling amounts. For example, if a stock breaks below identified key support levels, traders often sell as soon as possible.
A take-profit point is the price at which a trader will exit a stock or trade position taken and take some profits. Often this is when additional upside is limited given the risks. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation or downside price movement takes place.
Setting stop-loss and take-profit points is often done using technical analysis, but fundamental analysis can also play a key role in timing. For example, if a trader is holding a stock ahead of earnings as excitement builds, he or she may want to sell before the news hits the market if expectations have become too high, regardless of whether the take-profit price was hit.
Moving averages represent the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the 20 period MA, 50MA, 100MA and 200MA. These are best set by applying them to a stock's chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.
Another great way to place stop-loss or take-profit levels is on support or resistance trend-lines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. Just like moving averages, the key is determining levels at which the price reacts to the trend-lines, and of course, with high volume.
Calculating Expected Return/Profit Targets
Setting stop-loss and take-profit points is also necessary to calculate expected return. It enable the trader to know the returns that they are going to get for the capital that they are putting at risk on a trade. This prompts traders to think through their trades and rationalise them, and it gives them a systematic way to compare various trades and select only the most profitable ones.
The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade. The probability of gain or loss can be calculated by using historical breakouts and breakdowns from the support or resistance levels.
Traders should always know when they plan to enter or exit a trade before they enter the market. By using stop losses effectively, a trader can minimise not only losses, but also the number of times a trade is exited needlessly. Prepare your trading battle plan ahead of time to give yourself a high probability chance of winning the war. Through this you will achieve the consistency that is necessary to be a profitable trader.
Disclaimer – Futures, CFD, Margined Foreign Exchange trading, Warrants, Options and Spread Betting all carry a high level of risk to your capital. Only speculate with money you can afford to lose. Futures, CFD, Margined Foreign Exchange trading and Spread Betting may not be suitable for all customers, therefore ensure you fully understand the risks involved and seek independent financial advice if necessary.
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