BY RAVINDRA Jayananda

A share trader refers to a private share trader who trades frequently in the share market to create wealth. The long-standing investor in shares is basically interested in long-term investment and his behaviour and decision-making in the market will not be the same as that of a private share trader.

The first priority of a professional share trader is to ensure survival. Ensuring survival primarily means safeguarding your capital. In this regard risk management in share trading is an extremely necessary requirement to be a successful share trader.

First step in risk management involves how you would allocate your equity in shares. There are different models of equity allocation.

For example, equal portion model is one such model. In this case as the name implies, your equity is equally shared in a number of types of shares.

If your equity is Rs. 100,000, and if you invest in ten different shares, you invest Rs. 10,000 in each type of share. This is not an ideal model, as you do not take into account the volatility of each type of share.

Another model for equity allocation is Tier-type allocation. In this model you invest major portion of your equity in less volatile, more stable, blue-chip like companies.

For example, 50% of your equity can be invested in this type of shares with very low volatility. Then a lesser portion, say 30% of your equity can be invested in middle-level companies where the volatility of the share is moderate. The rest 20% of your equity can be allocated to highly volatile shares, with high risk and probable high returns.

How much to Risk

Once you have allocated capital to a share, you have to ensure that your losses are minimised.

A very important safety measure to minimise losses is to have a pre-determined level of loss and to never loose more than that. The maximum amount a trader may lose on a single trade without damaging his long-term survival should not be generally more than 2 percent of his equity.

For example, if your total available capital for share trading (equity) is Rs. 1,000,000, you should not loose more than 2% of your equity. That means that when the prices fall, if your loss surpasses Rs. 20,000, you must sell the shares. This is known as the "Two Percent Rule".

But some traders are much more careful, and they do not risk more than 1.5% or 1% of their equity on any single trade. The two percent rule provides a solid defence against damages. Even if you loose on six or seven of your share transactions, one after the other in quick succession, still you can manage to survive and will not harm your ability to recover.

Stops and Average True Range (ATR)

Another defensive measure in risk management is the concept of stops.

As soon as the professional trader enters into a trade he places 'a stop', beyond which, price he will not hold on to the share.

In deciding the point of stop, the concept of Average True Range (ATR) is used. As a simple definition of Range, we consider the difference between the highest and lowest prices of a share on a given day. Say yesterday the highest and lowest prices of a share were Rs. 30 and Rs.28 respectively.

So the range is 30-28 = Rs. 2. The Average True Range (ATR) is generally taken as the average of the past twenty such values. Some even consider average of five, ten or fifteen values for the ATR. Let us see how we use the ATR in deciding on a stop. Now for example, if the value of a share is Rs. 30 and the ATR is Rs. 2, then you allow the share to fluctuate up to twice the value of ATR. i.e. Rs. 4. That means if the value of the share falls below Rs. 26, you sell the share. However, if the share value increases steadily, you can move your stop upwards. First you may place your stop at break-even level where there is no gain or loss, taking into account expenses on taxes and commissions. This is called the break-even stop. If the value of the share rises further you can progressively move the stop higher and higher. If the gains are very high you may place the stop, corresponding to a value of even three times the ATR. In our previous example if the share value has risen from Rs. 30 to Rs. 50, you may place the stop at Rs. 44, taking three times of the ATR. The ATR is also not a fixed value, and it will change over time. It is because when we consider the most recent twenty values, the last value (21st day) drops off and the new value of today (1st day) is added. The difference of these two values contributes to the daily change in ATR. Allocation of equity Another safety measure is, not to invest more than 10% to 15% of your equity in one share. This is because when you have your eggs in more number of baskets they are comparatively safer. Final point of importance is the average monthly sales volume. That is the 30 days average volume of shares transacted. Generally as a private trader you should not purchase more than 20% of average volume of transaction of a particular share in the market. If you buy more than 20% of the total transacted volume, you become a significant player in the market. Then you cannot easily exit from the market, as your share volume is high compared to the total market volume. It is always safer to be an insignificant player in the market as you can enter and exit from the market easily and inconspicuously, at any given time.