Introduction

Many relates trading in stock markets as a form of gambling because we are betting on share price to rise when we buy long, and betting on share price to fall when we buy short. Some might agree trading stocks is a form of gambling while many would say that it is not gambling because of several reasons.

However, what really differentiates “gambling” in stock market versus real gambling in casinos? Isn’t gambling in casino better off as the results of your betting are decided or known in a matters of seconds rather than taking day(s), months or even years for tocks? The answer lies in recognising your risk.

By recognising your risk, you are able to identify the risk-to-reward ratio of anything that you are betting on. In terms of gambling in casino, the risk is simple in most cases, you stand a chance to win by the risk of losing all the capital when betting in casino.

However, in stocks, whether you are trading or investing, by adopting the prudent approach of recognising your risk, it is different as you stand a chance to win by risking only a small portion of your capital. In comparison, stocks provide a much lower risk-to-reward ratio as compared to gambling. Therefore, by clearly recognising your risk, you are able to control your risk-to-reward ratio, there after providing you with an edge whereby you will always win more than what you will risk losing, provided you have a proper trading plan and be discipline like how professional traders execute a trade.

Recognising your risk in trading does not need complicated formulas or perform calculations with programming software. It is as simple as thinking through the four possible risk aspects below and its mitigation where newbie or beginner traders can follow easily.

Risk of Losing Large Capital in a Single Trade

Mitigation: Enforcing Stop Loss

Determine your stop loss amount whenever you place a trade allows the risk of the trade to be sizeable. When what you will risk losing is known in terms of actual amount, it eases decision making.

For example, if you plan to place a trade at $1.00 with stop loss at $0.98, you know that for every 1,000 shares that you buy, you will risk losing $20 [($1.00 – $0.98) x 1,000]. If you believe the share price will have a potential to reach $1.20, your possible reward will be $200 [($1.20 – $1.00) x 1,000]. Hence, your risk-to-reward ratio is 1-to-10. These calculations are only possible if a stop loss has been put in place.

For beginners, it is always difficult to execute a cut loss as our mind will always have the hope that the share price will rebound and this irrational mindset is always hindering you from taking the prudent action to cut loss.

Although there are cases where, by not cutting loss and the share price does rebound and most newbies traders will be happy with these type of decisions/actions. However, this type of illogical actions of not following your trading plan will hurt you in the long run. The analogy is that these type of actions is equivalent to driving through the red light without getting into an accident on some occasions and you might be lucky for a few times but it would eventually cost you dearly if you continue to take risks with this type of illogical actions. It is the same in trading and investing!

Risk of Over-buying a Trade

Mitigation: Position Sizing

As discussed in previous “iVSA Article 8 - Develop a Trading Plan” (http://klse.i3investor.com/blogs/ivsatradingtipsandplans/97390.jsp), position sizing helps you to limit the risk exposure of your capital by buying the right quantity of shares in accordance to your risk per trade. Based on the above example, imagine if you have a capital of $10,000 and you will tolerate losing $100 for each trade, therefore your position sizing should be 5,000 shares as you are risking $20 for every 1,000 shares. This limits the risk exposure of your capital by only taking a position of 5,000 shares although your capital allows you to purchase 10,000 shares.

Risk of Buying a Non Performing Share

Mitigation: Understand The Company’s Financial

Gravity is known as one of the universal law whereby no wonder where you are on earth, things will always flow towards the direction of gravity. Similarly, in stock market, there is also a universal law whereby in a long run, share prices of companies with good financial performance will always move upwards after corrections/dips. Therefore, it is important for traders or investors to recognise the risk between buying a company with sound financial performance versus buying a company which is making losses continuously. Based on the universal law, the later will definitely have a higher risk even though the risk may not be too evident in the short run for some cases.

Traders will have to consider the relation of this risk to your intended trading timeframe. If your trade has an intended timeframe of holding for a period of 6 months or longer, the risk is lower for company with sound financial as companies with good fundamental and track records will typically recover from bad results in a few quarters. Moreover, profitable companies will usually pay dividends and these pay-outs will further lower your risk of making losses in that trade.

Risk of Buying at a Wrong Timing

Mitigation: Understand The Market Stages

As highlighted in previous “iVSA Article 6 - How to Detect Smart Money Movement” (http://klse.i3investor.com/blogs/ivsatradingtipsandplans/96519.jsp), it is important to understand the four market stages, namely Accumulation, Markup, Distribution and Mark Down. Ensure that your long trade is made during accumulation and/or at the beginning of markup stages and not during the other two stages.

Sometimes it is difficult to differentiate between accumulation and distribution stage as both of these stages present a similar sideways price movement trend. There is never a guaranteed way to differentiate these two stages but a trained iVSA traders will be able to differentiate the two stages. Back testing your entering strategy also helps in mitigating the risk of buying at the wrong timing.

Conclusion

Recognising your risk in trading allows you to perform the prudent assessment of risk-to-reward ratio or perform risk mitigations before you enter into any trade. These ensures that you are always playing on the winning side whereby the odds are most likely in your favour. It is very important, especially for beginners to be aware of these risks to avoid being over confident and driven by emotions that are stirred by tips and rumors, when placing any trades. This is one of the key aspects of how professional traders and investors are different from newbies traders. Remember this – “Trade when you have an EDGE, not when you have an ITCH!”

Watch out for next article in this series of education articles brought to you by iVSAChart, “Article 11 - Trading Journal” under Series B: Preparation Before Trading or Investing (what professionals worldwide are practicing).

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This article only serves as reference information and does not constitute a buy or sell call. Conduct your own research and assessment before deciding to buy or sell any stock. If you decide to buy or sell any stock, you are responsible for your own decision and associated risks.