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Assessing risk in stock trading

Assessing Risk in Stock Trading

As a trader, you can’t control the direction of the market. Risk is a fact of life.

As a trader, you can’t control the direction of the market. Risk is a fact of life. While you can’t force a trade to move in the direction you would like, you can plan ahead to decide when and how you close your position. This decision determines the potential gain or loss on a trade and should be reflective of your risk tolerance. Employing clear risk management objectives may help minimize the risk associated with any trade.

Recognizing that risk exists

Entering a trade is just the beginning; what you do once you’re in a trade is just as important.  Some traders initially ignore the importance of risk management, preferring to focus on maximizing profitability. They may spend hours gearing up to enter a trade. Once they are in a position, they are completely focused on the stock reaching its price target. Unfortunately, they don’t have a plan for when the stock does not move in the direction they had expected. Set expectations for your positions and your overall portfolio. Establish target prices for when you would exit a successful position, as well as when you would exit an unsuccessful position. Consider how a position may impact the overall diversification of your overall portfolio.

Questions to ask

Your view of risk and how you manage it is very personal. There is no single formula or approach that works for everyone. There are some things, though, that you may want to consider when evaluating your risk perspective: trading capital, exposure per trade, and risk/reward ratio.

1. Trading capital

For many individuals, trading is one part of their overall financial strategy.  Having several approaches that make up their overall strategy is a form of risk management. A question to ask yourself is how much of your investing and trading assets will be allocated to trading. Look at the role trading plays in your broader investing strategy to determine an allocation that works for you. For instance, if you are beginning to actively trade, have little experience, and don’t plan to devote a lot of time to it, you may not want to allocate a large portion of your portfolio to trading.

2. Exposure per trade

Going into a trade, determine the maximum amount of capital that you are willing to lose and allocate your capital accordingly. Trades you perceive as having more risk may merit a smaller allocation of capital than others.

You may be thinking, “Why would I want to enter a trade if I expect to lose money on it?”. That is a good question to ask and one that highlights a trading reality:  you will have losing trades. Knowing this, consider determining the point at which you will close your position.

So what should I be willing to lose? That is an individual decision. One way to look at it is by basing it on a percentage of your total trading capital. Known as the “One Percent Rule”, it seeks to limit your overall capital at risk to 1% of your trading portfolio. For example, if you have $50,000 in trading capital, your per trade risk, at 1%, would be $500. This amount is what you are willing to lose, not what you plan to invest. Your trading strategy and risk tolerance will determine what percentage loss per trade works best for you.

3. Risk/reward ratio

When assessing risk, another consideration is potential profit. You may want to look at how much you expect to make on a trade and use that as a starting point in determining how much you are willing to lose. Is risking a dollar to make a dollar a worthwhile tradeoff? Do you look for trades that you expect to deliver $3 for every $1 at risk? Are you comfortable risking $1 to make $3? If you do, will these trades allow you enough downside flexibility to account for pricing changes on the way to your target? Ultimately, the right ratio is unique to each individual and the trade itself. 

Applying risk management techniques 

Once you have spent some time evaluating your risk tolerance in light of your strategy, it is time to incorporate this information into your trade.  If you already know what conditions will cause you to get out of a trade, why not implement those at the time you enter that trade?  You can use tools like bracket orders to do just this. Then, when those conditions are met, your rules will execute and you take emotion out of the process.

Another benefit of establishing risk rules is that you can evaluate these against your performance on actual trades. Are you getting out of trades more frequently? That may be a good thing if you are apt to stay in losing trades for a long time. Conversely, you may have established rules that are too restrictive. Experiencing the benefits of pre-trade decision making just a couple times can provide the positive feedback you need to build a good habit. Not losing money can be very satisfying and can definitely help you stick with your trading strategy over the long haul.

Conclusion

As a trader, you may not be able to control risk but there are steps that you can take to manage it. The most important step is acknowledging that it exists and thinking through how you will deal with it. As it relates to trading, consider your motivations and strategy to determine how much of your investing capital you will commit to trading. At the trade level, prior to placing the trade, set points at which you will attempt to exit the position. Also, evaluate your planned exit points in light of what you expect to earn on the trade. Are you comfortable with the trade risk based on the expected return?

Establishing and implementing appropriate risk management techniques provide a sound backing for your trading strategy and give you a framework from which to evaluate performance.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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