The Trader’s Handbook Ep7: risk management essentials for traders

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In this episode of The Trader’s Handbook, The Finance Ghost and Shaun Murison dive deep into one of the most critical aspects of trading: risk management. Building on previous discussions around technical trading indicators, the hosts explore the concept of volatility and its significance in managing risk. They break down strategies like the use of stop losses, the impact of leverage, and the importance of position sizing.

Shaun shares valuable tips on how traders can protect their capital during high-risk situations using tools like guaranteed stop losses and trend lines.

Whether you’re a seasoned trader or new to the markets, this episode provides actionable insights to help you navigate market fluctuations and manage your exposure effectively.

Listen to the episode below and enjoy the full transcript for reference purposes:

Transcript:

The Finance Ghost: Welcome to episode seven of The Trader’s Handbook, my collaboration with IG Markets South Africa. it’s really good to have you here with us. In episode six, we gave you a pretty good taste of some of the technical trading indicators that are used by traders. Particular focus in that show was on moving averages and MACD, which has nothing to do with McDonald’s and everything to do with trying to help you do better in the markets. And Shaun, I think it was really fun to just start chatting through some trading indicators, so we’re going to do some of that today as well.

But we are also going to start out with a discussion on risk management. And that’s because these technical indicators, as great as they are – it’s quite an information download and it’s quite a lot to absorb when you’re listening to a podcast. And that’s why we include the charts in the show notes as well. So if you want to engage with the technical trading content as best you can, then make sure you’ve got the show notes open in front of you so you can actually look at the charts that are being referenced as Shaun walks us through that.

Certainly for the risk management stuff etc. you luckily don’t need any charts in front of you. You can sit back with whatever drink is in your hand. Shaun, you’ve got a coffee in your hand from what I saw there. Thank you for joining us and I look forward to doing this one with you.

Shaun Murison: Great, it’s good to be back.

The Finance Ghost: Risk management, that is pretty much key to the process, isn’t it? We know from the statistics that retail traders generally speaking have quite a tough time with risk management and only a relatively modest percentage of traders are really successful. A lot of that must surely come down to risk management. I think let’s start with just the absolute basics.

People hear market commentators, they read it in the media etc. about market volatility. That is ultimately the focus of risk management. I’ll hand over to you to just walk us through what volatility actually is at the end of the day, and then we can dive into more risk management topics.

Shaun Murison: Yeah, so I think just starting off, risk management is key in trading. I think everyone’s always concerned about when to buy and when to sell, the timing of the market. But if you commit too much money into the wrong trade, you’re going to get yourself into trouble.

So, you need to understand volatility. You need to manage that risk. You can have a strategy where you are right nine out of every ten times, but you could still be loss-making, because if you commit too much money to that one time that you’re wrong, you’re going to give away all your profits.

When we talk about volatility, essentially we’re talking about the range of price movements, whether historical or implied in the future. So if we talk about a share price, commodity price, FX price, whatever you’re trading, small price movements suggest low volatility. A large range of price movements between the high and the low is considered high volatility. When you’re looking at shares, for example, let’s say a share moves 3% in a day between the high and the low. It’s obviously more volatile than a share that moves, on average, about 1% over the course of the day. Higher volatility gives you a higher degree of risk, but also a high opportunity for reward, which still needs to be managed. In a highly volatile market environment, you might consider having smaller positions in the market. In a low volatile environment, you might consider having slightly bigger positions to try and magnify that reward.

The Finance Ghost: This is the old story, right, about how things don’t go up in a straight line. That’s exactly what volatility is. You look at a chart and you see all the little squiggles. Yes, there might be a broader trend, up or down or even sideways. Sideways is also a trend, but it’s not a straight line unless it’s an incredibly illiquid stock that never trades. You get those, but they’re not of any help to traders whatsoever. If you’re looking at a stock that actually has activity in it, you’re going to see lots of up and down moves, and that ultimately is volatility.

Volatility is not just about these black swan events that make it into the headlines, right? It’s not just the big moves, like -20% or -30% in a day because something crazy came out. Recently, we saw Barloworld close 12.5% lower on Friday the 13^th – can’t make this stuff up. That was because they just went and released an announcement about some disclosure they’ve had to make around potential export control violations to Russia. This is stuff that’s really, really difficult to manage, these black swan events, and we’ll get to that shortly.

Volatility is more than that. It’s actually all the small moves as well. As you pointed out, it’s the extent of the moves both up and down. It’s how a share price moves over time within a trend. Just back to those black swan events, I’m not sure that Barloworld’s announcement is quite a black swan. I think 12.5% down is a big “owie” as my little guy would say, but it’s not quite a black swan.

As you pointed out before, though, IG does have a guaranteed stop loss for those sort of scenarios. We’ve talked about stop losses before, which are a way to manage your downside risk – basically stem the bleeding at a point in time on the chart. But if a stock really gaps down, and that means that bids just disappear in the market and the only bid is a long way down and someone is willing to sell down there and the stock gaps lower, that can go right past your stop loss, as I understand it, unless you have taken out this guaranteed stop loss. I just want to confirm with you that that understanding is correct. Just practically on the platform, when you’re executing a trade, how do you do this guaranteed stop loss? Is it available on every stock or every index or every asset on the platform? How does it actually work?

Shaun Murison: Just going back to stop losses, for new listeners, a stop loss is obviously just an order to exit the market if it moves unfavourably against you. With a normal stop loss, like you correctly said, sometimes we’ll wake up and the market might just open lower and past our stop loss. If you had bought and you’re looking to sell to somebody, there’s no one to sell to, but your order in the system would be to get me out if it gets to this price or below.

What can happen in that situation is you actually end up losing slightly more than what you expected to lose. We refer to that as slippage. Now, slippage can work in your favour when you’re placing orders as well, but in that scenario, you’d lose slightly more than what you expected. A guaranteed stop loss is a function that IG does offer to say, well, if it does get to this price, even if it gets lower, we honour that price and we’ll get you out of that price. So, very simply, you can just add that to your trade. When you’re placing a trade on the IG mobile app or on the platform, you just choose what type of stop you like.

Now, if you use a guaranteed stop, there is a slight premium associated with that, obviously, because now we’re taking on that risk for you to try stop you from getting that slippage. But it’s a really, really cool feature. It means that you can rest assured that this is how much, in a worst case scenario, if the trade’s going to go against me, how much I’m going to lose, and there will be no surprises on that front.

The Finance Ghost: And in terms of the availability of that guaranteed stop loss, is it available on everything?

Shaun Murison: Yes. Yeah. It’s available across all the different asset classes.

The Finance Ghost: Okay. And that’s on the platform. When you’re putting your normal stop loss in, you have that option on the platform?

Shaun Murison: Yes, when you place the trade, you have an option of three types of stops. There’s a normal stop loss, which we’ve discussed, and I just don’t want to say you’re always going to get slippage. I think if the market’s illiquid or if you’re trading shares, you’re more likely to get slippage because of gap risk. The markets close and open, but some of the continuous markets like forex indices, you’re less likely to get slippage because they are trading pretty much 24 hours with IG.

The Finance Ghost: Yeah. Part of what we’ve discussed in stop losses previously, and I would encourage our listeners to work back through the content, was looking at stuff like the typical range that a stock will trade in, or an asset or an index or forex or whatever the case may be, and using that to inform your stop loss decision, because it doesn’t help to put your stop loss at a point where there might be your typical daily volatility and then you basically just locked in a day’s loss for no real reason, no real benefit. It’s there for risk management, not making sure you lost money on a slightly bad day.

Shaun Murison: Can I just add in there a very, very cool technical analysis indicator? It’s very easy to use.

It’s called average true range. You add that indicator to your chart, it’s going to give you that information. It’s going to show you, on average, how much that particular share or that index or that FX price moves over the course of a day, an hour. All you have to do is just add that indicator to your chart. You look at the value, and then you can really have an expectation of what is a probable move.

We can’t always tell the future. We don’t know when you’re going to have those black swans or an outsized moves in the market, but you look for what’s probable. And that indicator, average two range, abbreviated to ATR, is something I’d encourage anyone new to technical analysis and charting to just add to a chart and take a look at because it will give you an expectation of how much that market moves on a normal day. If you apply it to a daily chart, over an hour, if you apply to an hourly chart, five minutes.

The Finance Ghost: Yeah, and there was actually a great piece on that in Ghost Mail this past week. What I’ll do is I’ll include that link in the show notes, and I recommend listeners go check it out. That IG Markets Academy is just a wealth of knowledge. And obviously there, first you get to look at Shaun’s very professional photo at the top of the article. But once you make your way past that, you’ll also find some really useful charts. It’s a great read that I highly recommend.

I think let’s talk about leverage, Shaun, because that is really the reason why volatility is so important to traders, even more than investors. And what I mean by that is, for me, for example, coming from an investor background, if I’m just sitting on a stock or an ETF or whatever it is I’m invested in, if it has a really bad day and it’s down 10%, I’m not forced to sell. I’m not sitting there with a leveraged position. I can just hang on to it. I might want to sell if I think it’s going to go much lower. Or I can ride it out and say, actually it looks like it was overcooked.

In fact, if I have a relatively modest position, and I think it was a silly move, then I can jump in and take the opportunity. It happened earlier this year when Cashbuild dished out this absolute gift. There must have been a big seller in the markets, as there was no reason why the share price behaved the way it did. I said thank you very much, and jumped in, and it worked beautifully. But it is less risky when there’s no leverage.

With trading CFDs, there is leverage, and obviously that adds to the risk. It also adds to the potential return. That’s the golden rule of finance. You can’t get the bigger return without taking a little bit more risk. In a risk management show, we need to to at least do a quick recap on leverage. It’s something we have talked about before, so let’s not spend a lot of time on it. I think just a quick recap on how the leverage works in CFDs and then why that is so important in the context of volatility?

Shaun Murison: I think leverage essentially magnifies moves in the market because you’re putting a deposit down for your trade. If you wanted R100,000 worth of shares, you might be asked to put a R10,000 deposit. Your profits or losses are magnified by ten times. It actually enhances that volatility. And the reason you use that magnification is to help you get in and out of the market quickly, because trading is seen as short-term. A 1% move essentially works out to a 10% move if you’re looking at ten times leverage or ten times gearing, so you don’t have to be in the market as long.

You could also use the analogy of putting down a 10% deposit on a property, let’s say a R1,000,000 property and putting down R100,000. The capital gains come from that R1,000,000 property, not from the deposit. That’s essentially how you could look at short-term trading and leverage, because essentially, when you’re buying a house, you are leveraging yourself.

The Finance Ghost: Likewise, if that property goes down 10%, you effectively lost your whole deposit. That’s exactly the point, because the layer of equity in this thing is quite thin. It’s like what happens in a private equity investment. You typically have a lot of debt and a relatively modest layer of equity. If it does well, you shoot the lights out in terms of return on what money you actually put in. But if it does badly, you can effectively wipe out the layer of equity and this leads me directly into my next question. Let’s say you put down R1,000 on a R10,000 position for easy numbers. If it drops 10%, the asset that you invested in has effectively lost your entire R1,000. I understand that. But what happens if it drops 15% and you weren’t sitting with any kind of stop loss? Is there an automatic system on the platform that basically gets you out of the trade before you lose more than your deposit? Or can you actually lose more on that one specific trade than your original deposit, before dipping into the rest of your balance sitting with IG?

Shaun Murison: That’s a very good question, because you always see the headlines, when you talk about derivative trading, CFD training, you can lose more than your deposits, but the answer to that is both yes and no, right? If you’re trading with IG, different brokers might have different models on that, but you are always in your account required to have the deposit or your margin for the trade you have open and any loss that you may be incurring.

So, if you don’t have enough money to cover the deposit in your trade, and because you’re incurring a loss and you don’t have sufficient funds in your account, then we do have an automated system which can close you out of that trade, which should stop you from losing more money – in the negative situation, more than your initial deposit. We talked about things like gap risk and market dislocations, sudden movements, you know, Barloworld 12% lower and things like that, in which situation you’d still get closed out of the trade, but you would lose more than your initial deposit. The good news is, there’s a way of ensuring that you don’t lose more than your initial deposit. And that’s by using what we referred to earlier on as a guaranteed stop loss. Because there, you are guaranteed to get out where your stop loss level is. You will not lose more than your initial deposit for that trade. That’s why I said the answer is yes and no. If you are using things like guaranteed stop loss, then, no, you cannot lose more than your initial deposit on a trade.

The Finance Ghost: Thanks, Shaun. That’s super helpful. I think let’s move on now to another angle to risk that isn’t as commonly considered or talked about, which is an order not filling to the level that you actually wanted it to. Now, I would imagine in something like a pairs trade, which we discussed a couple of shows ago – go back and check that out if you missed it – that can be quite an issue because you suddenly sit with a very different mix of exposure to what you expected.

Let’s say you expected to be long a thousand shares of one thing and short 500 shares of the other. And because of the different prices, you end up with the exact long-short mix you were looking for. If one of those trades doesn’t fill completely, you know, let’s say instead of shorting 500, you could only short 300, or instead of only long 1000, you could only get 800 shares, then suddenly the trade is not actually what you thought it was going to be. Let’s talk through that as a source of risk. Why do trades sometimes not fill? How does this work in practice and what can traders do about it?

Shaun Murison: Look, when you buy, you’ve got to buy from somebody, and when you’re selling, you’ve got to sell to somebody. Maybe the volume or the number of shares you want to buy or sell is not the matching volume on the other side. So that is a risk, that you can’t get the volume of the order that you’re looking for. You might get a partial fill, things like that, but there is an easy way of remedying it if you are trading on the IG platform. You activate the direct market access function, the DMA function, or what we call level one or level two access, and then you can actually see what volume is available on the platform, in the market, in the underlying market before you place your trade. That’s just one way of mitigating that risk.

The Finance Ghost: Yeah. And I mean, there’s not much you can do about it, right? If, as you say, there isn’t someone to sell to or buy from, this market can’t just be made out of thin air. That’s more of an issue on the illiquid stocks, which I guess is part of why you don’t offer every single stock on the platform, because liquidity can be an issue.

Shaun Murison: Exactly. That’s 100% right. It might be an attractive stock, but if no one’s really trading it, then you might get in, but you struggle to get back out of that particular company.

The Finance Ghost: Yeah, absolutely. Look, I think we’ve now dealt with a few things around risk, and there’s really only one more that I want to cover before we have a brief conversation on a couple of technical concepts. That is position sizing, as well as any other risk management tools that you think might be worth discussing.

Let’s do that. Why is position sizing so important as a risk management tool? And do you think there are any others that we maybe should have spoken about on the show that we haven’t touched on?

Shaun Murison: Like I said earlier on about the position sizing, committing too much money to the trade where you’re wrong can wipe out all the profits from the trades where you’re right. That is one of the things that we do see. Bad habits in trading include overtrading and trading too big.

There’s a very simple formula there to help with that position sizing. A stop loss manages the risk on your trade, but you need to decide what your total risk is. How much money are you prepared to commit to any one trade? Is it 1% or 5% low risk relative to high risk?

In that formula I like to give, when you’re looking at shares, you take that total risk and you put it into monetary value, and then you divide that by your risk per share or your stop loss distance, and then that’ll give you a number of how many shares you should trade. So total risk divided by your stop loss distance will give you the number of shares you can trade. Very simple formula. And that should help you with your position sizing, managing your risk within the market.

You asked about other ways of managing risk. Well, we did talk in one of the previous episodes about peer trading, hedging out risks or market-neutral positioning. Another one that I think is often overlooked is don’t overtrade, you don’t always have to be in the market. Sometimes sitting on your hands is actually a trade. Being patient and waiting for opportunity is a way of mitigating risk. It’s okay to miss out rather than lose out sometimes. There are always opportunities arriving in the markets. Just waiting for the best ones, I think, is quite prudent and is a form of risk management.

The Finance Ghost: Yeah. Fantastic. Let’s do today’s little technical section because we have a few minutes left and there’s some good stuff to talk through. Today we’re going to look at trend lines. So that includes trend lines, support lines, resistance lines, all very interesting things. I’ll just let you run through all of them in one shot. What’s nice with these is I think support and resistance lines are something I’ve used with relative success in some of my investing, because it really is one of the easiest things, in my opinion, to see on a chart. If you’ve ever looked at a share price and you’ve wondered why did it move, I don’t know, 6% and not 8%, then you zoom out a bit and you have a look that it stopped at a level that it’s been at before, either up or down. And you see those support and resistance lines, it’s amazing how visible they are on a chart. That for me was the sort of entry point into technical analysis and believing that actually there’s a lot of value in this stuff because support and resistance lines do work.

Shaun Murison: So, yeah, starting off with trend lines. We have talked about moving averages. Moving averages are essentially an automated or dynamic trend line. But a trend line is just drawing a line along the lows, the price. If they’re going higher, it gives you an idea of market direction. We know they’re in an uptrend. Draw it along the top, so the market’s falling, linking lower highs. You can see the market is in the downtrend. A lot of what we do is trying to align our trades in technical analysis with the general trend of a market.

Trend lines are another way of just helping assess general market direction. You can use those for support and resistance, but I think what you’re referring to and what is my preference as well, the most important indicator to me is just a simple horizontal line on that chart.

And that horizontal line marking major turning points in the market, major lows, we call it support when you draw it underneath because it looks like it’s holding up the price and making turning points. We put lines above the tops of that. It looks like a bit of a ceiling because it looks like it’s stopping the price from moving higher. We can sort of get an idea of where buying has come into the market, where selling has come into market, and buying support is an area where buying has come back into the market.

Resistance is an area where selling has entered the market. So that gives us an idea of price expectation. Resistance gives us upside targets if the price is going up. Support gives us a downside target if the price is going down. And if it’s acted as support in the past, we can see that may be a buying opportunity or area where we could look at accumulating that particular share or company or whatever asset class you’re trading.

The Finance Ghost: I think it’s an important risk management tool. It’s not just about what the opportunity is in front of you, but if something has fallen from a resistance line all the way to a support line, and that’s your moment where you decide, okay, I’ll short this thing. You’re not playing the charts at all. You’re literally going short at exactly the point where a bunch of people say, hang on, I’m going to buy this thing now. And as you said from the very beginning, the market is really just this great big voting machine. It doesn’t actually matter whether something is fairly valued or not. It matters how people perceive it and what they are willing to do. And if enough people believe, hey, this is a support line I’m going to buy here, and that’s the exact moment at which you go short, you’re not managing your risk and you’re probably going to have a bad time (on average).

Shaun Murison: One of our earlier mentors said markets always move to where the orders are. And, you know, the support levels often show us where those orders are. Just something I’ve always kept in mind. I believe in support because the price, the balance between buying and selling pressure has changed. In future, we don’t know what’s going to happen, but we’re looking at the probability of what’s happened in the past. And so that to me is where orders are in a place where I can get involved in that market as well.

The Finance Ghost: Yeah. Fantastic. I think this has been a really, really good discussion as usual. We’ve touched on some technical stuff. We’ve touched on some other stuff. I would certainly encourage our listeners to go and check out the other shows in this series. This is now episode seven. There are six other great shows to go listen to, and there will be several more as well. As always, you’re very welcome to let us know what you would like us to cover. You can contact either one of us through the various social media channels or, you know, use the contact form on the Ghost Mail website, for example, or comment on the podcast. We’ll see it wherever you try and put it.

We look forward to doing this again next time, Shaun, and giving more insights. Thank you very much and see you for episode eight.