The importance of risk management and capital protection cannot be overstated when trading in the financial markets. Many online brokerages now offer conditional orders like stop losses to their clients and this has gone some way toward addressing the issue, but risk management goes a lot further than simply setting a stop loss.

When a trade is placed, there are a couple of different types of risk that need to be thought of and planned for.

Trade Risk — This is the risk that the individual share you have bought will plummet and your investment will be worth nothing. Some ideas for mitigating trade risk include setting a stop loss, using a capital allocation method and only risking a set percentage of your capital in any given trade.

Market Risk – this is the risk that the entire market will fall, and wipe out your entire portfolio.

Unfortunately, the only way to entirely mitigate market risk is to refrain from trading in the markets. The happy news is that even though we cannot totally get rid of market risk, we can go a long way toward making it manageable and we can keep it at a point where we feel safe in the market and can sleep soundly at night.

Many risks are involved in stock tradingPortfolio Heat – A Risk Management Tool for Traders and Investors

Portfolio Heat is a tool that ensures that only a set percentage of an investors capital is ever exposed to the market at any one point.

For example, Jane the Trader has an account worth $100 000 to trade with, and she never risks more than 1% (or $1000) of her account on any one trade. By risking only $1000 on each trade, Jane is protected from trade risk, but not from a broad market crash. If Jane had 20 new positions and the market crashed, she could lose 20% of her account in one fell swoop.

To protect her portfolio against an across the board fall, Jane could implement a Portfolio Heat strategy. To do this she must determine a few parameters.

Firstly, she must decide on a level of loss that she would psychologically feel comfortable handling in one day. This is usually a percentage of total equity or capital, for example, 6%. This means that in Jane’s case, the most she feels she could comfortably lose in a crash would be $6000.

($100 000*0.06).

This heat percentage will be different for everyone and should be set in line with each investors risk profile, but as a general guideline between 5 – 10% is usually acceptable.

Once a heat percentage has been decided upon, it will guide the trader or investor as to how many new positions may be opened at any one time. In Jane’s scenario, she could never have more than 6 new positions open at any one time. Because Jane risks $1000 on her trades, by limiting her new positions to just six she ensures she never has more than $6000 at risk in the market.

Protective Stop Loss

It must be noted that this does not mean she is limited to six positions in total. As soon as any position moves into profit and its protective stop loss is moved to breakeven, the position no longer has any capital at risk and therefore no heat allocation.

This also applies to trades that get stopped out at a loss. Once a traders’ capital is safe the position no longer counts toward the heat percentage and it means that a new position may be opened.

Using Portfolio Heat will allow traders and investors alike to rest easy at night, knowing the market only has access to a small percentage of their capital. Market crashes are rare but they can be permanently scarring to a traders psychology, and even if their account is relatively unscathed from the emotional impact of a substantial loss must be considered.