What is Risk Management?
Traders and investors should have a risk management plan to limit the potential massive losses that can come with involvement in the stock market. Options contracts can drop significantly over time periods as short as a few seconds or minutes. Simple shares, while risky, can still yield the same significant drops in short time periods due to news events or general direction. Risk management allows traders and investors to limit their losses in this case through a stop loss.
A stop loss can be either manual or a mechanical stop through a brokerage trading platform.
How can Portfolio Diversification limit Risk?
A key part of a risk management plan is to have a diversified portfolio. This is because when you have a portfolio that is too heavily invested in one sector, if the sector as a whole sees a sharp decline all your positions will follow. Sectors such as technology and healthcare have recently provided massive returns in the past few years but have taken some of the largest hits in this year’s bear market as well.
A good rule of thumb is to not have more than 10 percent of your portfolio in any one sector. To understand the different sectors in the market it is a good idea to take a look at the S&P 500’s different sectors.
Stop Losses to Limit Risk.
Stop losses can come in many different variations depending on investors’ risk appetite. Some traders like to set their stop loss on their brokerage app as a mechanical percentage or dollar amount stop out. Meaning, if they have lost a certain amount or percentage that they input they will be exited from the position at a limited loss. Other traders and investors look to set their stop losses based on some brief technical analysis. They will look to exit positions at break or hold of certain key levels they have plotted on their tickers or indicators that they are watching.
Risk management is arguably the most important component of protecting your capital when investing or trading in the stock market. Without proper risk management, you put yourself at risk of blowing your entire portfolio through bad trades with no exit plans. Be safe and practice risk management in your investing journey!
Your Fellow Stock Hackers
Erwin and Cherry
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That’s all for now.
Happy trading and investing,
Your fellow Stock Hackers,
🍒Cherry & Erwin
P.S. The market dropped almost 20% between January and June this year. Will the market continue to crash? What can you do if it does crash? We unpack all of these questions in our latest FREE report, “What to do if the Market Crashes in 2022.” Download your free copy now!