Suvankar Talukder

Financial risk management is how you play the defensive half of the investment game.
The purpose of risk management is to ensure that your investment losses never exceed acceptable boundaries by following disciplined practices including position sizing, diversification, valuation, loss prevention, due diligence, and exit strategies.
The reason risk management is essential - not optional - is because the amount you lose during the tough times determines how much you must make during the good times to meet your financial goals.

You must preserve your capital during difficult periods so that your offensive investment strategy has a larger base of capital to grow from when profitable times return.
For example, imagine a football team with such an effective defense (risk management strategy) that they never give up a first down to their opponent. This team will be very tough to beat because their offense doesn't have to score many points to win, and they will have most of the game to do it since the defense will spend so little time on the field.

The same is true with investing.
Financial risk management controls the investment game. It keeps the line of scrimmage near break even so the offense doesn't have to make up for losses when executing the next play.
It preserves capital when the opponent is pounding away at you so that the next touchdown is new profit rather than recovered losses.
Investing without risk management is like being a quarterback without a front line to protect you - eventually you will get slaughtered
In other words, investment risk management is the secret to safe, consistent profits in any market condition.
Few investors understand that without a proper risk management plan you are literally one bad investment from the poor house. By managing risks you can reduce the odds of financial destruction to as close to zero as mathematically possible.
If your objective is financial security, then risk management should be your primary focus.
Remember, you can't make money when you are busy losing it.
 
As Chinese military general Sun Tzu's famously said: "Every battle is won before it is fought." The phrase implies that planning and strategy - not the battles - win wars. Similarly, successful traders commonly quote the phrase: "Plan the trade and trade the plan." Just like in war, planning ahead can often mean the difference between success and failure.
Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan ahead when trading. Successful traders know what price they are willing to pay and at what price they are willing to sell, and they measure the resulting returns against the probability of the stock hitting their goals. If the adjusted return is high enough, then they execute the trade.

Conversely, unsuccessful traders often enter a trade without having any idea of the points at which they will sell at a profit or a loss. Like gamblers on a lucky or unlucky streak, emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits often entice traders to imprudently hold on for even more gains.

Stop-Loss and Take-Profit Points
A stop-loss point is the price at which a trader will sell a stock and take a loss on the trade. Often this happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the "it will come back" mentality and limit losses before they escalate. For example, if a stock breaks below a key support level, traders often sell as soon as possible.

On the other side of the table, a take-profit point is the price at which a trader will sell a stock and take a profit on the trade. Often this is when additional upside is limited given the risks. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation takes place.

How to Effectively Set Stop-Loss Points
Setting stop-loss and take-profit points is often done using technical analysis, but fundamental analysis can also play a key role in timing. For example, if a trader is holding a stock ahead of earnings as excitement builds, he or she may want to sell before the news hits the market if expectations have become too high, regardless of whether the take-profit price was hit.

Moving averages represent the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the five-, nine-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a stock's chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.

Another great way to place stop-loss or take-profit levels is on support or resistance trendlines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. Just like moving averages, the key is determining levels at which the price reacts to the trendlines, and of course, with high volume.

When setting these points, here are some key considerations:
  • Use longer-term moving averages for more volatile stocks to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
  • Adjust the moving averages to match target price ranges; for example, longer targets should use larger moving averages to reduce the number of signals generated.
  • Stop losses should not be closer than 1.5-times the current high-to-low range (volatility), as it is too likely to get executed without reason.
  • Adjust the stop loss according to the market's volatility; if the stock price isn't moving too much, then the stop-loss points can be tightened.
  • Use known fundamental events, such as earnings releases, as key time periods to be in or out of a trade as volatility and uncertainty can rise.
Calculating Expected Return
Setting stop-loss and take-profit points is also necessary to calculate expected return. The importance of this calculation cannot be overstated, as it forces traders to think through their trades and rationalize them. As well, it gives them a systematic way to compare various trades and select only the most profitable ones.
This can be calculated using the following formula:

[(Probability of Gain) x (Take Profit % Gain)] + [ (Probability of Loss) x (Stop Loss % Loss)]

The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade. The probability of gain or loss can be calculated by using historical breakouts and breakdowns from the support or resistance levels; or for experienced traders, by making an educated guess