The Importance of risk management in stock market

The Importance of risk management in the stock market

In this blog, we will discuss the most important topic of the stock market that is risk management. Risk management is a very underrated topic among retail traders because nobody tells them or maximum retail traders avoid risk management as they think this will cut their profits. If you want to profit in the stock market you need to calculate your risk and size your trade. As you are familiar with the term 90-90-90. 90% of retail traders lose their 90% capital in 90 days. Why you need to read this blog because we found out that some trades trade well their winning trader are more than losing trade still they lose money. In this blog, we will discuss how to overcome this problem?

Standard terms used in risk management:

1. RPT  : Risk per trade.
2. RtoR : Risk to reward ratio
3. Hit rate

Risk to reward ratio

1. We all know what is risk to reward ratio and how to calculate it but you also need to know the trade expectancy. 
2. E.g. If your risk to reward ration is 5:1 which is a very good for every trader but what is the probability of stock moving up 5 percent rather than 1 down percent to cut your stop loss.
3. Let say Probability of market moving up or down is 50-50.
4. But with the technical analysis we can increase it to 60:40 or 70:30 or 80: 20 or 90:10
5. E.g. Stock price is 100 your risk to reward ration is 2:1 and probability of stock moving up is 50:50. Probability of  stock moving to 102 is 50% whereas Probability of stock moving to 99 is 100%. If you take 3 trade probability of hitting 102 is 1 and probability of hitting 99 is 2.  
6. By this setup your trade ends up in losses after the deduction of all the brokerage, taxes and other expenses.
7. Therefore With at least 60:40 probability and 3:1  risk to reward ratio will help you to become a profitable trader.
8. With the increase in the probability you can increase the risk and reward ratio.

Hit Rate = Continuous losing trade

1. E.g. If you have 100 in your trading account 
2. Your trading set up win rate = 50%
3. Risk to reward = 2:1
4. 50%  win rate = 1 win and one lose 
5. 1 loss = -1 points
6. 1 win = 2 points
7. 2-1= 1 point profit on every 2 trade.
8. However the distributions of winning trades and losing trades is never be like Win-lose-win-lose-win-loss-win-loss.
9. Distribution of winning and losing trades is completely random
10. To calculate the hit rate We need to calculate how much we lose?
11. 1-0.5=0.5
12. Probability that trader losses is 50%
13. To calculate the hit rate we multiply the chances of first trade losing by the chance the second trade loses = 0.5*0.5= 0.25 %
14. This means the probability of losing 2 trade continuously is 25%
15. Probability of losing 3 trade continuously is 12.5%
16. Probability of losing 4 trade continuously is 6.25%
17. Probability of losing 5 trade continuously is 3.125%
18. Probability of losing 6 trade continuously is 1.5625%

This is all the probability you can lose 6 trade continuously. Ask yourself and prepare yourself how much a question what happens to my capital if I lose 6 trade continuously?

Risk per trade calculation

1. Let say you take 10% risk in every trade so after losing 6 trade your new worth will be down 60% .
2. It will be ex termly difficult to come back from this point 
3. What is the maximum risk on can take in overall portfolio?
4. The answer is 10-15 %
5. Therefore your Risk per trade will be 2-3 per trade on 2:1 risk to reward ratio.

• Why implied volatility increase or decrease in options?

• How to find reliance industries correlation with nifty?

• How to calculate implied volatility for nifty options?

• Learn the basics of implied volatility?

• Option chain implied volatility and options greeks calculation excel sheet download