What is Risk Management and how to Manage Risk in the Stock Market

Stock market provides the same chance for investors to take their return, but so many investors can't earn enough returns and lose money, why? Because they don't know what is risk management and don't use it.

What is Risk Management?

Risk management is the process of measuring, or assessing risk and then developing strategies to manage the risk while attempting to maximize returns. Typically involves utilizing a variety of trading techniques, models and financial analyses.

The potential return from any investment is generally depending to the amount of risk the investor is willing to assume.

Investors will not take on greater risks without the possibility of higher earnings. This is called the risk premium. In general, the greater the risk, the higher the potential return; the lower the risk, the lower the expected return.

Common types of Risk

There are several main types of risk, and investors should understand them well because some affect certain investments more than others.

The two common risks that apply to almost all investments are:

Market Risk: The chance that financial markets in general may rise or fall in value.

Inflation Risk: May be the most important factor for long-term investors to consider, because inflation is cumulative, and it compounds just as interest does.

You can't control the inflation risk, but with a good strategy you can manage and control the affect of market risk on your stocks.

A professional trader always tries to understand and control portfolio risk. Before entering into any trade, good traders first think about how much risk to take and how much risk exposure comes with a particular trade selection. Only then do they allow themselves to think about how much profit they stand to make.

Prudent investors always close their position and exposure if they determine that a portfolio carries too much risk.

Risk Management for a Trade

• Before you decide to trade consider to these fundamental principles:
• Before you trade a stock, know how much you are willing to lose.
• Check the stock to be sufficiently liquid, can you buy or sell promptly?
• Determine the cut-loss level before trading.
• Determine your profit target (take-profit-level).
• Buy the stock only at an acceptable price level. Use a limit order when you buy a stock.
• Immediately after the trade has been confirmed, enter the stop-loss-at- market order at your predetermined stop-loss level.
• Take profit when the trade reaches your profit target.

For example: so many traders determine their cut-loss level 2% of their capital and they call it 2% rule. If you own 1000 shares of X at $100 with a $2 stop loss order in place, your risk is: $2 * 1000 = $2,000. So long as you have capital amounting to at least $100,000 on hand, you would not be considered to be in breach of this "rule".

Portfolio Risk Management

Whit managing the risk of each trade your portfolio risk will be well under control and you manage your portfolio risk actively, but to control your portfolio risk management better notice to these points:

• Determine your overall cut-loss level. Usually your portfolio should not lose more than 10% of your capital.
• Diversify your investment in at least six or more different stocks.
• Know your overall risk tolerance before building up the portfolio.
• Act quickly when you see your risk limits exceeded.
• Close out the entire portfolio if it loses to your overall stop-loss level.