Stock trading risk management

If you have finally taken the decision to learn about trading and investing in the stock market, then there are three terms which you must be familiar for conducting any action in the stock market, which are, the stock exchange as a whole, the economy of the country, and mutual funds.

The stock exchange is what we call the stock market. The place where we transact in the stock market is the stock exchange.

The economy refers to the general economy of the country. For example, the national economy of the United States will undoubtedly have a huge impact on the stock market as well. But in the stock market, the topic of discussion may also be the kind of economy the world in general is witnessing. There are many factors which influence the economy of the United States. Some of them are the trade deficit or surplus, level at which the inflation is, interest rates decision by the federal, the political scenario, etc. The overall condition of the economy determines the stock market trend. It gives the market players a fair idea about how much money people have to invest in the stock market. For instance, if inflation is at a higher level, consumption of people on consumer goods may increase, and savings may decrease. So people will have less investible funds, and it will indicate a clear downtrend in the stock market levels.

Mutual funds are distinctly related to the stock market. In fact, mutual funds comprise of many companies shares which are floated in the stock market. For instance, a mutual fund based on infrastructure may have holdings in many infrastructure companies of the stock market, which diversifies the investors’ portfolio and reduces his risk, since even if one company fails to make money, the other company can cover up for it. Some mutual funds may be growth oriented, so they may have significant holdings in blue-chip companies. The biggest advantage of mutual funds is that the variety of stocks in a single fund, which, mind you, are selected and monitored by expert fund managers, reduces your risk to a great level. The only disadvantage is that most of the mutual funds have a very high entry and exit load, which eats up a chunk of the profit that you make. But still, if you are a new investor and are yet to learn the nuances of the stock market, then it is best to take shelter in mutual funds. When the markets fall like a pack of cards, then mutual funds may be a good place to hide in. Even though you may incur losses here as well, your losses will be lesser than the general fall in the market, or say, in a particular script.

At one time, there was so much risk involved in trading that it was given another name -gambling! That is not the case now, and that is mainly because there is a concept of risk management in the stock market. No doubt, trading in the stock market is very risky even today, and an investor with a callous attitude is bound to lose money. It can never be denied that for a newbie, investing in the stock market is like playing with fire. The main reason for this risk is the volatile nature of the stock market.

There are two kinds of people in the market:

the bulls (optimistic people) and the bears (the pessimistic lot!). When the latter takes over the charge, the stock market witnesses a huge correction, thus giving sleepless nights to numerous investors. They enter the market without any intimation, and leave as fast as a hurricane. But not before doing the damage. You may be surprised to know that a huge correction may lead to a fall in the stock prices by over 50-60%. In extreme cases, they may fall to as low as 20% of their value prior to the correction.

Risks are inevitable in the stock market, and a common cause for corrections is a hike in the federal interest rates. If there is a significant hike in the interest rates, then the investors tend to sell of their position in the stock market and invest in securities with fixed income, like the bonds, fixed deposits, and other funds in the money market. When there is huge selling pressure in the market, share prices only fall. This causes a huge loss to investors, more so for those who have bought the shares at a high price.

The risk due to currency fluctuations cannot altogether be ignored. When the currency becomes strong, then people suffer loss if they are holding securities of foreign markets. On the flip side, if the local currency weakens, then the investors are a happy bunch as they get good returns on their investment. The local currency is subject to constant fluctuations, and it would surely affect the investors who are short-term players in the market.

The key to reducing losses is diversification. In the stock market, the common adage always holds true ? Never put all your eggs in one basket. The ones who suffer the most are those who play for short term gains in the market, more so for those who invest in equities. There are many investors in the stock market who are not much educated about the need to manage their portfolios properly, and they don’t have the required knowledge to evaluate fair value of shares. They simply lose money because they just put their money in a particular script blindly, and regret when due to their inability to predict, the share price starts falling.