Have you ever wondered how successful investors negotiate the stock market minefield and protect themselves against losses?
We did. And we found out: while you can’t ever escape risk altogether, you can certainly manage it, if you know a few tricks of the trade.
Here are six techniques that successful investors use to stop risk running away from them and open up the prospect of profit - so you can put them into practice too!
You can use stop orders to maximise profits and limit your losses even if you don't have the time to follow market movements.
Stop loss orders protect you from plummeting share values by telling your broker to sell if prices go against you.
It's as simple as this: you set the bid value and your broker will automatically offload your shares if they drop to that level. This gets you out of the trade before prices fall even further, where you'd make an even bigger loss.
Alternatively, you can set stop buy orders on falling shares that you expect to grow in the future - do this and your broker will automatically buy stock on your behalf if the price hits the offer value you've set.
Most online brokers will let you fix stop orders to run months at a time assuming your trigger limits aren't reached.
The risk: reward ratio is based on weighing potential profit against potential loss.
You can not only use it to help you choose which shares to invest in, but also to work out where to set stop orders so you minimise losses and maximise profit.
Essentially, the risk: reward ratio assumes that you'll still make a profit if at least a third of your trades are successful.
It states that you should only ever make investments where indicators say the likely reward is at least three times the risk and the idea is that higher the ratio, the better the investment.
However, the ratio relies on indicators and advice so it's not infallible and you should exercise caution with every trade.
For example: shares currently worth £3, expected to rise to £9. In this case, setting the stop loss order to £2 would give you £6 potential profit versus a £1 potential loss, a risk-reward ratio of 6:1.
One of the most successfully used types of stop loss orders are 'trailing' stops. These update daily to follow movement in share price and limit your potential losses to a level you're comfortable with.
The 'last three days' rule is an oft-used type of trailing stop order; it instructs your broker to sell if the share value falls back to its lowest position of the past three days, thus protecting any profits made and preventing loss.
For example: if a £6 share’s lowest value over the preceding three days was £3, £4, then £4, your broker would sell if its value fell to £3 during the current day's trading. The stop loss order then updates itself to a £4 sell price for the next day.
Limit orders (also known as options) reduce the risk of buying too high - or selling too low - by guaranteeing the price at which you can buy or sell shares.
You’ll often have to pay an upfront arrangement premium but you'll be able to choose from a number of different options, one of which is put options.
Put options give you the right to sell a particular asset at a particular price, for a certain amount of time. Depending on the price specifed under the contract, this can protect you from falling share value and mean that you're able to sell the stock for more than its current market value.
The added bonus is that while you can sell at any time during the contract term, you're under no obligation to do this unless you want to.
For example: you buy a put option for shares worth £8 each, that guarantees a sell price of £6 per share. If their value falls to £4, you'd be able to use the option to sell them for the £6 contract value, or you could wait for their price to rise again.
Call options guarantee the price at which you can buy a particular asset, for a fixed period of time. Effectively this means that you can buy stock for less than the current market value.
However, as with put orders; you don’t have to invoke it and you can just let the option expire without buying.
For example: you suspect shares valued at £5 will grow but don't want to risk investing just yet, so you purchase a call option for £5 per share. If the share value rises to £7, you could still buy them for the £5 contract value while the option lasts.
You can also sell covered call options for your stocks and shares. This gives the other party the right to buy those shares at a set price, rather than giving you the right to sell.
Covered call options earn you money if the option isn’t used – usually if the shares perform either neutrally or poorly – so can give you short term income on longer term assets.
Of course, the downside is that if the shares do perform well during the contract term you have to sell.
For example: you own shares valued at £10 each, and you sell a covered call option for £11 per share to a third party. If the share value stays the same or falls the third party won't use their option, so you keep the option premium as profit.
Take a look at our action plan, How to Start Investing in Shares, for a step by step guide to achieving your investing goals.