For every rupee of profit a trader makes, there must be another trader losing that rupee. As an extension of this phenomenon, if there is a group of traders consistently making money, there is another group that is experiencing significant losses. However, the number of people profiting from the stock market may be less than the number who lose. And what differentiates a successful trader from a non-successful one is their understanding of risk and its management.
Mark Douglas, an extremely successful trader, mentions in his book “The Disciplined Trader” that successful trading is 80% money management and 20% strategy. The money management part involves largely assessing the risks. Therefore, understanding risks and how they influence emotions and decision-making in trading has become crucial for traders today.
Understanding risk psychology
The stock market is abundant with fluctuations in price, volatility, and uncertainty, which significantly impact trading decisions for participants. It is also evidently prone to trade risk, which is the potential for financial loss or negative consequences when trading an instrument on the stock market. However, on the other side, if the risk is managed with efficacy, a reward awaits the trader, which is the profit they make.
This is where a lot of traders fail to realise the risk and seek an edge to reap more profits. A common saying that goes around is ‘the greater the risk, the higher the potential for profit.’ However, the point that is missed is that there is also a high chance of bearing significant losses, which most of the traders do. A study conducted by the Securities Exchange Board of India (SEBI) stated that nine out of ten traders in the F&O (future and options) segment lose money. Therefore, it efficiently proves that trading is a risky affair, and it significantly impacts emotions and decision-making.
Risk-impacting emotions
While in a trading session, a trader goes through a myriad of emotions; however, the primary emotions that are dominant are greed and fear. On one hand, taking excessive risks owing to the propensity to overestimate one’s abilities can lead to greed taking over the minds of the trader. Here, greed motivates an individual to maximise their capital as soon as possible. It may tempt them to also borrow money and trade it without fully comprehending the hazards involved.
On the other hand, being too risk-averse can lead to loss-aversion biases, which refer to avoiding losses at all costs. Here, the trader is driven by fear and may be more sensitive to losses than gains, leading to exiting a position too early. Therefore, striking a balance between the two is crucial for traders.
Risks influencing decision-making
Perceptions of risk in trading are an essential part of the decision-making process in the stock market. As an individual, everyone has different abilities for comprehending, facing, and dealing with risks. Prospect theory here defines this phenomenon in a perfect manner. It assumes that losses and gains are valued differently, and thus people make decisions based on perceived gains instead of perceived losses.
This essentially proves that risk can influence the decision-making of a trader and can lead to suboptimal outcomes. This is where a trader needs to develop a risk attitude, which is a general tendency to avoid or seek a risk in a given situation. It is further influenced by personality, experience, emotions, values, beliefs, and goals.
Effective risk management techniques
On every single trade, the traders face the risk of losing their capital. Therefore, in a bid to win over the long haul, one has to implement robust risk management strategies that limit the risks and maximise the profits. This process includes determining an individual’s risk appetite, knowing the risk-reward ratio, and protecting the capital from a long-tail risk or a black swan event.
Minimise losses: The legendary trader Ed Seykota defines three rules for successful trading, and each of them constitutes ‘cutting your losses.’ One rule of thumb for minimising losses is to never lose 1% of the trading capital in one session.
Hedging: One crucial risk management strategy is hedging, which requires the use of offsetting positions that make money when primary investments bear losses.
Diversification: Portfolio diversification is a strategy that includes owning non-correlated assets so that it reduces the overall risk without losing expected returns.
Stop-loss orders: This involves selling a position if it hits a certain price point below a predetermined threshold. The limit of loss can be subjective to different traders based upon their risk appetite.
All things considered
For traders, the key to staying profitable in the stock market is to keep their losses smaller than their profits. In a bid to make this possible, it is essential to understand the psychology of risk and how it influences one’s emotions and decision-making.
Moreover, after comprehending the intricacies of risk, traders must implement effective risk management strategies such as minimising losses, hedging, diversification, stop-loss orders, and more. The most important point to note here is that risk is subjective and can differ with respect to an individual’s experience, appetite, knowledge, goals, and more.
Therefore, one must always know when to leave the trade, as it will help them to assess the risk-reward ratio and be more lucrative in the stock markets.
