Set rules to deal with risks in common situations

Different types of trades can be compared in terms of risk management. Managing risks involves getting a sense of the quantum of risk and setting up controls like stop-losses to limit losses. It also involves getting a sense of the possible payoffs since a risk cannot be judged in isolation without knowing the corresponding reward.

Trades can be divided into many different types. For example, there are trend-following trades and there are trades, which go counter-trend. A third type of 'non-trending trade' picks stocks that may develop uptrends. This is actually a description of a fundamental investment.

Trend and counter-trend trades are often made by mechanical rules. When following an uptrend, traders set stop losses below entry price. If the trend sustains, the stop is moved up and the trade is held. If the trend fails, the stop is hit and an exit is made. These rules are reversed when a trend-following trader shorts a downtrend. A "counter-trend" trader shorts when an uptrend seems unsustainable, or buys when it seems a bottom is hit on a downtrend. Again, stop-losses are set and exits made if stops are hit.

Such trades are almost always leveraged and often use instruments that directly impose timeframes. Assuming disciplined execution and careful sizing of positions, the trader has a good idea of maximum loss. Trend followers and counter-trend traders may or may not have targets. But, they have minimum expectations: they hope to make more on wins than they lose on the failures.

In contrast, an investment is usually without mechanical rules. The investor looks for stocks with some fundamental strength. Such a stock may or may not have a trend. Very few investments have stop losses, price targets, or clear timeframes.

What risks do such vanilla investments run? This is usually not leveraged, so that's one potential risk eliminated. But, the other risks don't disappear because those are left un-quantified. It is useful to set a mental stop-loss, to take opportunity costs into account, and perhaps, set potential minimum price targets, or expectations.

The lack of a clear stop-loss could mean agonising decisions, if losses slowly mount. There is always the temptation to hang onto a losing trade and hope it will turn favourable. Another point is that, without a clear target or some minimum expectations, the investor lacks a system for booking profits. Again, this might mean making hard decisions about booking profits or losses.

There is also the possibility of an investment which doesn't see much price change. How long will the investor hold in such cases? Opportunity costs must be taken into account and the return must be compared to the risk-free rate of return.

The point is, setting rules forces the trader to explicitly consider such questions, to understand individual risk-appetites and quantify risks. There are other psychological advantages to setting rules. When rules are mechanically followed in disciplined fashion, the trader has fewer critical decisions. Hence, the trader is less likely to make mistakes under pressure due to ego or nervousness.

When he or she makes a profit or a loss, it comes from following preset rules. The state of mind doesn't matter, nor does the ego, as trades unfold. This is useful because it enables the individual to maintain calm and a calm trader is more likely to be a winning trader.

It's possible to make money trading trends, or trading against trends, or ignoring trends and making investments. But, it helps to think the risks through and to set simple rules to deal with the situations that commonly arise.

The author is a technical and equity analyst