Risk management is defined as a plan to reduce the likelihood that you will lose money. Risk is the potential loss of money but it is not the actual loss of your funds. With a risk management plan, you don’t want to avoid risk, instead you want to have a plan on how to deal with risk. To make money you need to take risk or accept the risk-free rate that you can reach from either a bank or government treasury bill. You will experience risk with both short term trading strategies, as well as long term buy and hold techniques and there are risk management strategies that you can use to deal with each.
What is Risk
Risk is the potential to lose money. If you are trading the capital markets, you are accepting the risk that is inherent within these markets. You get paid to take risk. The reward for taking risks should be a return that is higher than the risk-free rate of return. For example, if you deposit your money at a bank and they are paying 0.5%, you want to make sure that your capital markets trading is making more money that this rate over time.
What is Risk Management
Risk management is a plan on how to deal with specific risks. You want you risk management plan to deal with your entire portfolio as well as each individual trade. At the trade level, risk management can be how much you are willing to lose to achieve the profit potential of the trade. Each trade in each strategy should conform to a risk management plan at the strategy level.
Before you allocate capital to a given strategy you should have a plan that describes the risk management. Lastly, you want all the capital in your portfolio to be part of the overall risk management strategy.
Long Term and Short-Term Risk Management
You might have several different portfolios. One might be discretionary income that you want to use today to increase your wealth. You also might have a retirement plan and a college savings plan. Each allocation of capital needs to have a risk management strategy.
Online trading risk management requires a stop loss on each trade and a take profit or trailing take profit. These terms describe when you will exit a position, either by taking a loss, or receiving a profit. A trailing stop loss allows a trading to continue to follow the trend in a market and exit when the market finally turns.
Long term trading requires diversification. You want to make sure that you are trading several different assets which will help you avoid losses during adverse market conditions. For example, if you have a buy and hold long term strategy, you want to make sure you have several different assets so if the value of one goes down, you will have other assets to offset those losses.