Hedging Strategies

Today we’re going to uncover what is arguably the most crucial element in a trader’s arsenal: risk management. If you’ve been following the series, I’m sure you’re thinking, “Okay, but haven’t we talked about risk in the balancing risk and reward post?,” give us a chance. We promise to make this as exciting as a high-stakes poker game, and just as rewarding. Risk in Trading Explained To break it down, let’s assume you’re a tightrope walker, the safety net below is your risk management strategy, the other side of the tightrope is your profits and such. Just from looking at it, we all know the risks, but at the same time, we presumably see the profits at the end of the line. To face facts, the net (your risk management strategy) is the only thing keeping you from actually seriously hurting yourself. Let’s go on to say that the higher the rope is from the ground, the riskier things become. You can either choose to have your net an inch away from the rope or, much closer to the ground. Now here’s the thing, if your net is too high, you’ll become very reliant and dependant on it, and might not feel the need to take the tightrope seriously. You’ll play it safe, and your profits will stay grounded. On the other hand, if your net is too low, well, suffice it to say that it wouldn’t make a different if there were a net or not. Depending on your preference in the trading world, your rope may be 3 inches from the ground, or it could be 100ft from it. There typically isn’t a one-size-fits-all strategy because the strategy itself depends on factors such as you as an individual, the market(s) you’re in, your risk tolerance, and more. There could also be external factors at play. Think back to the 2008 financial crisis. At that time, the perceived risk in investing went from being the market standard to something else, and even the best risk management strategies resulted in substantial losses. There’s a minor typo, “other had” should be “other hand.” Here’s the corrected sentence: “But on the other hand, it’s because of crises like these that more fail-safes were implemented to significantly reduce the likelihood of future events like this. Risk & Psyche Now, let’s shift our focus for a minute to psychology and its relationship with risk. When we talk about the behavioural aspect of risk, we’re essentially examining how emotions, instincts, and biases impact our risk management decisions. Consider the well-documented phenomena of “fear” and “greed.” In trading, these two emotions often become major players on the scene, driving traders to make irrational decisions. We talk more about this in our previous post but to further emphasise the point, let’s talk about the GameStop (GME) incident. In early 2021, GME saw a meteoric rise in its stock price, driven largely by retail traders on Reddit’s WallStreetBets. Many small investors were caught up in the trend, driven by the fear of missing out on potential profits. Unfortunately, as the stock price soared to unsustainable levels, greed took hold, and many lost substantial sums when the stock plummeted. How to Manage Risk in Trading Now that we’ve covered the significance of risk management, you might be wondering how to put these concepts into practice when trading. I stand with my aforementioned statement about there not being a one-size-fits all, but here are a few helpful rules of thumb: 1. Determine Your Risk Tolerance: Before diving into any trade, assess how much risk you can comfortably handle. This is a deeply personal factor and can vary from one trader to another. Some traders can stomach higher levels of risk, while others prefer a more conservative approach. Knowing your risk tolerance will guide your position sizing. 2. Set a Stop-Loss Order: A stop-loss order is your safety net. It’s an order to sell a security once it reaches a specific price, preventing further losses. It’s a powerful tool to ensure your losses are controlled. Just remember, a stop-loss should be placed at a level that doesn’t get triggered by normal market fluctuations. 3. Diversify Your Portfolio: The age-old saying “don’t put all your eggs in one basket” holds true in trading. Diversification means spreading your investments across various assets and markets. By doing so, you reduce the impact of a poor-performing asset on your overall portfolio. 4. Use Risk-Reward Ratios: Before entering a trade, set a risk-reward ratio. This ratio determines how much you’re willing to risk for a potential reward. A common rule is the 2:1 ratio, meaning for every dollar you’re willing to risk, the expected reward should be at least two dollars. 5. Stay Informed: Keep an eye on market news and events. Sudden, unexpected developments can cause significant market swings. Being informed allows you to make adjustments to your positions or risk management strategies accordingly. 6. Emotional Control: Emotions like fear and greed can wreak havoc on your trading strategy. Be aware of these emotions and how they might influence your decisions. If you’re feeling uneasy, it might be a good time to reassess your strategy. 7. Regularly Review and Adjust: Risk management is not a set-it-and-forget-it strategy. Periodically review your risk management techniques and adjust them as necessary. As your trading style evolves, so should your risk management. 8. Learn from Your Mistakes: Every trader makes mistakes. The key is learning from them. If you incur a loss due to poor risk management, take it as a lesson. The market is your greatest teacher, and every experience, be it good or bad, can contribute to your growth as a trader. 9. Consider Professional Guidance: If you’re new to trading or still apprehensive about risk management, consider seeking advice from a mentor or professional trader. They can provide insights and guidance to help you navigate the intricate world of risk management. Wrap Up It’s very important to remember that risk management is not about avoiding … Read more