We often hear that a huge number of people lose money in the Stock Market. This is certainly true, not because of the wrong decisions you've made during a trade, but the lack of plan to mitigate the loosing situation. This plan is called Risk Management. As defined by investopedia: In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
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Now, you are very aware that a stock is always uncertain of where it wants to go, be it up or down. You can prepare by studying its historical trends, technicals, fundamentals, and even its latest news, but even with this knowledge you still can't 100% predict the stock movement. The only thing that can save you from further damage if a stock moves against you is to manage your risks.
Mandatory Requirements in Risk Management
- Set your Investment Portfolio Amount/Capital.
- Set the amount you are willing to risk from your Investment Portfolio Amount.
- Know your Entry Price (EP).
- Know your Stop Loss Price (SLP).
I've already completed the requirements. What now? The next step is to determine the number of shares to buy.
Computing the Number of Shares to Buy
First you need to determine the amount you are willing to risk for a trade. For example, you have 50,000 as your investment capital and you are willing to risk 5% of it. The computation will be:
Risk Amount: 50,000 x 5% = 2,500
2,500 is the amount you are willing to risk for every 50,000 stock trade.
Second is to get the difference between the Entry Price and Stop Loss Price. For example, you entered at 28 and set a stop loss at 26. The computation will be:
EP and SLP Difference = 28 - 26 = 2
If a trade goes south, you are willing to loose only 2 points before exiting a trade. Your principle here is to live to fight for another day.
The last process is to divide the Risk Amount with the EP and SLP Difference. The computation will be:
# of Shares to Buy: 2,500 / 2 = 1250
You need to buy 1250 shares to stay within your computed risk management plan.
Obviously, you cannot always buy the exact number of shares because it is determined by the set board lot. All you need to do is to round up or down the number of shares to buy. Say for example, the board lot of the stock is 100, then you can buy either 1200 or 1300 shares.
Points to Remember
- Always set the capital amount you want to deploy on a stock
- The Risk Amount must be constant across all trades based on your capital
The main goal of Risk Management is to protect your capital and your gains from being wiped out. Don't be part of the statistics where you lose money, be part of the winning side.
Stay tuned for the Risk Managed Shares Calculator that accounts both buying and selling fees.
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