Ace investor Warren Buffett once famously said: “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.”
Buffett was talking about investments in financial markets. However, there is another aspect to this - if someone is making profit in a trade, someone else has to be making a loss. This holds true especially for the derivatives market that is a zero-sum game.
There will be days when you might feel like the Warren Buffett of the stock market, and there will be days when something as innocuous as a fat finger can burn a hole in your pocket.
Here, we will explore how to reduce the chances of incurring a trading loss or at least minimise them.
What is Trading Loss?
When a person sells a financial asset at a price lower than the purchase price, plus any carrying cost, it is referred to as a trading loss. This kind of loss can be incurred in stocks, bonds, commodities, forex, or any other financial instruments.
The reasons for a trading loss can vary from market volatility, poor investment decisions, changes or even Black Swan events that can change the dynamics of the markets. Even a smart investment decision can go wrong in case of extreme market volatility due to geopolitical events. Every smart investor applies strategies that minimises such losses.
Tips to Reduce Trading Loss
Effective risk management strategies are essential to minimize potential trading losses. Here are some tips to reduce trading losses:
1) Hedging: Most financial markets offer various kinds of hedging tools to ensure that your losses, if any, are minimised. Traders should ensure that they have a proper hedging strategy in place so that they can protect themselves from market volatility. Of course, hedging has cost of its own. But this cost may not be as high as the loss a trader might have to take when bets go wrong.
2) Stop Loss:Most financial trading platforms will offer a stop loss risk management tool to limit potential losses. Basically, it is an order to the broker to sell a security when it reaches a specific price.
Traders, as soon as they buy a security, should determine the percentage of loss they are willing to take on it. Thereafter, they must inform their broker about the value of the stop loss they want to set on the security. For example, if you have bought a security for Rs 100 and you don’t want to take a loss of more than 10% on it, then Rs 90 should be your stop loss. Meaning, the broker should sell your security if prices fall to Rs 90.
Apart from the maximum loss that a trader is willing to take, a stop loss strategy is also based on the price beyond which price of the security can rise or fall rapidly. Technically referred to as support or resistance, these levels too can guide a stop loss.
The stop loss level should align with your overall trading strategy and risk tolerance.
A stop loss strategy is a smart way to manage investments, mainly in volatile or uncertain market conditions.
3) Stop Loss adjustments: Setting a stop loss is not a one-time thing. One has to keep updating it based on market movements and trading strategy. Let’s say you were to buy a stock at Rs 10 and set a stop loss at Rs 9. If the stock rises to Rs 15 and you see more upside, but want to exit with a profit in any case of fall, then you can change the stop loss to say Rs 12. Here you will make minimum profit of Rs 2 on the security.
4) Margin pressure: There are various tools that offer trading on margin money. One should be very careful of over-betting as the money initially invested may seem small. However, the losses that one might incur may be massive and the securities kept as margin may come under pressure. One should also be very careful when doing margin trading of where to stop and how much to bet.
5) Don’t put all eggs in one basket: Traders must ensure that they have diversified their investment pool into multiple assets so that a loss in one of the securities does not lead to a massive hole in the wallet. Diversification is one of the most important principles of safe trading.
6) Follow the news: Make sure that you are abreast of any news that may have wider ramification on the market or on any particular security that you are exposed to, either through spot or futures market.
7) Technical charts: Various tools are available to assess possible support and resistance for a stock based on past performance of a security and other parameters. A trader should keep an eye on such charts to assess potential losses and take action in advance to keep it at the minimum.
8) Beware of herd mentality: Traders should be aware of risks associated with following the crowd or making investment decisions based on what others are doing. They should rather rely on individual analysis and judgment. Such herd mentality has often led to market bubbles, which ones burst, leads to significant losses. To minimize trading losses, it's crucial to conduct thorough research, maintain a disciplined approach, and make decisions based on sound financial and economic principles rather than getting swayed by market trends or popular opinion.
9) Don’t marry a stock: Many traders get emotional about a security on which they have had high hopes in the past. This makes them reluctant to let go of it even in case of mounting losses. One should be careful not to be over-possessive about any security or trading position.
10) Put risk management in place: A trader should set alarms for any sharp movement in market, especially those that can cause a plunge in value of the asset they are holding. A robust risk management helps avoid or at least minimise trading losses.
Conclusion
To prevent or reduce trading losses needs a mix of disciplined investment practices, independent analysis, continuous watch on fundamentals, technical and news, and control over emotions. Traders must avoid the pitfalls of herd mentality, should follow comprehensive research and a clear understanding of market dynamics. Employing tools mentioned above, like stop loss, can provide an additional safety net against unforeseen market fluctuations.
