Navigating High Seas of Share Market: The Paramount Importance of Risk Management in Trading

In the unpredictable world of share market trading, the potential for financial gain is matched only by the inherent risks. One key aspect that separates successful traders from the rest is their unwavering commitment to risk management. Understanding and effectively managing risks is not just a prudent approach; it's a lifeline that ensures survival and prosperity in the volatile seas of the share market in the long run.

The Foundation of Risk Management

Risk management in trading is akin to a ship captain charting a course through stormy waters. It involves identifying potential hazards, deploying protective measures, and having contingency plans in place. The foundation of risk management lies in acknowledging that losses are an inevitable part of trading, and the key is to control and minimize them. Losses are the fees we pay for learning better trades.

Preservation of Capital:

At the heart of risk management is preservation of capital. Seasoned traders understand that preserving their trading capital is paramount for long-term success. Once capital is depleted through large, uncontrolled losses, the ability to participate in future opportunities is severely compromised. For instance, it takes 50 % depletion of capital from Rs. 1,000,000/- to reach Rs. 500,000/- but it takes 100% appreciation of capital from Rs. 500,000/- to reach Rs.1,000,000/- once again. 

Position Sizing:

Effective risk management starts with an effective position sizing. Traders determine the size of their positions based on a percentage of their overall capital. By limiting the exposure of each trade, even a series of losses won't cripple the trading account. In the context of retail traders active in NEPSE, with the tools available, risking no more than 10% of total capital on any single trade would be a very good decision. This exposure for institutional level should be much lesser, around 1-2%.

Stop-Loss:

Stop-loss acts as the emergency brakes in a trading strategy. Traders set predetermined levels at which they will have to exit a losing trade, preventing further damage. For instance, if the trader buys a share at Rs.200/- and sets a 5% stop-loss, the position will have to be sold if the share falls to Rs.190/-.

Furthermore, continuing our example above, if we set aside Rs. 100,000/- per trade out of Rs.1,000,000/-  total capital and kept hitting stop-loss in 5 trades out of 10 but gained an average of 20% in the remaining 5, we would still end up at Rs. 1,075,000/-  before commission and taxes.

Diversification:

Position sizing and diversifying a trading portfolio is a powerful risk management tool. By spreading investments across different sectors, traders reduce the impact of poor-performing trades on the overall portfolio. If one sector experiences a downturn, shares in other sectors may perform well, helping to offset losses. Following is the example using NEPSE data through random selection of sectors and shares. For easy understanding, we have not considered frictional charges such as commissions & taxes and also have assumed our 5% stop-loss has been hit after delivery of shares. As a further limitation of the example, rather than considering daily fluctuations, we have considered the closing prices of two dates.

Here, we see our time-bound swing trading strategy spanning one month from the 8^th of November, 2023 to the 7^th of December, 2023 has resulted in Rs. 40,910.64/-  ( i.e. 4.08%) return. We have hit a stop-loss in the hydropower sector which resulted in a loss of Rs. 5,000 rather than Rs. 6,747.30. In the example, a monthly return of 4.08% would also suggest a compounded annual return of a massive 61.58%. 

Real-Life Example from the Past: The Tale of Long-Term Capital Management (LTCM):

A cautionary tale that underscores the importance of risk management is the story of Long-Term Capital Management (LTCM). In the late 1990s, this hedge fund, led by Nobel laureates and financial experts, experienced a spectacular collapse due to excessive leverage and inadequate risk management. Despite their intellectual prowess, the fund's failure serves as a stark reminder that even the brightest minds can falter without proper risk controls. 

Conclusion:

In the fast-paced world of share market trading, risk management is the compass that guides traders through uncertainties. It is not about avoiding risks altogether but about navigating them wisely. By implementing strategies such as position sizing, stop-loss, and diversification, traders can safeguard their capital and enhance their ability to thrive in the dynamic and unpredictable world of the share market. As the saying goes, "It's not about how much you make but how much you don't lose," and this principle lies at the heart of successful trading through effective risk management.

Article By- Astitwa Sharma