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According to the Oxford dictionary: “Risk is a situation involving exposure to danger. To risk is to expose (someone or something valued) to danger, harm or loss.”
In trading, risk management is the use of processes to control, minimise and protect trading capital from the dangers of financial markets. Defining risk parameters is the first step in managing losses in both size and frequency. The main tools of risk management are position sizing, stop-loss levels and diversification. The main reason traders are unprofitable is large losing trades and large drawdowns. The first step in reducing risk is always to keep losses small and acceptable.
Risk can arise in many ways
A trader’s first risk is that any individual trade can fail. This risk is unavoidable, but in most situations we can control the maximum amount we lose through proper position sizing and stop-loss orders.
Market risk. You may pick a great stock of a company with strong fundamentals, but if the overall market is trending down – at a time when stocks as an asset class are seen as less attractive than gold, crypto or other assets – your stock is highly likely to fall too, however solid its fundamental value. A bear market is like a powerful storm that eventually sinks even the strongest ships.
Volatility risk usually arises when you trade highly volatile stocks, which can be measured with standard deviation or beta. Volatility risk can affect traders’ psychology, causing them to sell too early, or simply make a trading system ineffective as it keeps getting stopped out.
Overnight risk arises when a trader holds a position overnight and unexpected news breaks while the market is closed. This can cause large price gaps the next morning when trading reopens. Overnight risk can be limited if you are a day trader, opening and closing positions within the day. However, this is almost impossible with cash equities in Vietnam because of T+2 settlement restrictions.
Liquidity risk arises when there are few buyers or sellers in your market, forcing you to buy or sell at a large price spread if you want to trade a large volume. You can see the very wide spread in WCS (197–200) caused by low liquidity, compared with one of the market’s most heavily traded stocks, such as FLC.
Margin risk – also called leverage risk – arises when a trader uses securities positions as collateral and borrows money from the brokerage firm to buy more shares. Once you have opened a margin account, most brokers will let a trader or investor buy more shares and even more than double their account’s buying power. With margin, a trader can use a VND 100 million account to buy VND 200 million worth of shares if the brokerage grants that stock a 50% margin ratio (learn more in our separate article on margin ratios). The advantage of margin is that a trader can make larger profits when they are right, but the risk is correspondingly higher when they are wrong.
There are also some basic human-error risks, such as entering a sell instead of a buy, entering the wrong quantity, or even typing the wrong ticker (I have made this mistake myself). Double-checking trades before sending them to the market is a simple but extremely important step.
One of the most frustrating types of risk is technology risk. Trading when everything works normally is hard enough, but a trader can also lose their internet connection or face an overloaded trading system (we saw this on HOSE in early 2021, when a surge in orders jammed the exchange’s system). Anything can happen while you are trading, so be prepared for everything.
One of the fundamentals that decides a trader’s success is how well they manage risk. Here are some rules to keep in mind to limit basic risks
Diversify your portfolio
Spreading your portfolio across many stocks in a range of sectors and market-cap groups can help limit unsystematic risk while optimising returns during unstable market periods.
Hedging
This is a way to limit risk on a portfolio of cash equities using derivatives. For example, you can reduce risk on your portfolio by shorting VN30F futures contracts when you see signs that the overall market is about to correct sharply and may turn down. The profit from shorting the futures will offset the losses on your stock portfolio, provided the position sizes are comparable.
Set a stop-loss
This is a prerequisite for every trade: every order must always come with a stop-loss level. If the share price slides, you certainly cannot stubbornly hold on hoping it will reverse, because that will only make your losses bigger (some people end up as reluctant “value investors”). Set a sensible stop-loss based on a percentage decline – 5%, 7% or 10% – or at an important technical support zone (see the Technical Analysis section for details).
Calculate a sensible position size
Here is a simple problem: suppose the stock you want to buy is priced at VND 50,000 and you set your stop-loss at VND 45,000, a risk of VND 5,000 per share. If you buy 1,000 shares, a VND 5 million loss may not be too large, but if you buy 20,000 shares, a VND 100 million loss is a figure few people could accept. That is why you need this rule. Set a risk limit per trade as a percentage of your account, say 2% or 5%, and define your stop-loss; from that you can calculate the maximum position size you allow. For example, with a VND 1 billion account and a per-trade risk limit of 5% of the account, or VND 50 million, you should buy at most 10,000 shares of the stock above.
Don’t trade unclear setups
If you are a technical trader using several indicators that confirm one another, and at a given moment the moving average gives you a buy signal while the Stochastic gives you a sell signal, that is an unclear setup. In this case, it is better not to enter the trade.
We will meet again in more in-depth articles on the fascinating topic of risk management in trading.
Happy trading!
The “Stock Trading For A Living” Course
Green Chart designed this course to give students a solid foundation in fundamental analysis and stock valuation, and to show them how to integrate it effectively into their existing trading system, especially for traders who already use technical analysis. The programme includes five theory sessions and six months of hands-on trading practice in the real market with the lecturer.
See full course details here.
