TradingKey - Investing in stocks is like an exhilarating adventure. Some have doubled their wealth, while others have lost everything due to poor risk management.
Why do people continue to jump into the market despite shouting “The stock market is risky”? The answer is simple—there are high-return opportunities here that are hard to find in other investments.
However, it is precisely because of the high-risk, high-reward nature of stock investing that risk management has become a crucial lesson for every investor.
What is a Stop-Loss Order?
In simple terms, a stop-loss order allows you to set a selling price in advance.
When the stock price drops to this point, the system automatically liquidates your shares to stop additional losses.
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How to Set a Reasonable Stop-Loss Order?
Setting Stop-Loss Orders Based on Technical Analysis
Technical analysis is a widely used method that helps determine stop-loss levels by observing stock price trends, chart patterns, and technical indicators. Here are two commonly referenced tools:
- Support Level
Visualize stock prices as a ball; the support level functions like the ground—when the ball makes contact with the ground, it bounces back up.
For instance, if a particular stock repeatedly rebounds around 20 yuan, then 20 yuan serves as its short-term support level.
If the stock price drops below this level, it may signal a trend reversal. In this case, setting a stop-loss order can help you avoid increasing losses as the price continues to fall.
- Moving Average
Short-term moving averages (such as the 20-day moving average) indicate short-term trends; long-term moving averages (such as the 200-day moving average) reflect long-term trends.
If you're engaging in short-term trading and the stock price falls below the 20-day moving average, it may indicate an end to upward momentum—thus consider setting a stop-loss order.
For long-term investments, breaking below the 200-day moving average could signify prolonged weakness—this might be when you should exit your position.
However, it's essential to note that technical analysis isn't foolproof; unexpected market news or manipulation by major funds can render these indicators ineffective.
Setting Stop-Loss Orders Based on Capital Management
If you prefer not to engage with complex charts, try using a simpler percentage-based stop-loss method. Set limits on how much you can afford to lose per trade; it’s generally advised to keep this within 1%-5% of your total capital.
For example, with a total capital of 100,000 yuan and wanting to limit losses per trade to no more than 5%, you would place your stop-loss at 5% below your purchase price.
If you buy a stock at 10 yuan, and then set your stop-loss at 9.5 yuan—the trade will automatically sell when it reaches this price.
The benefit of this approach is its simplicity and mechanical nature—it enforces risk control and helps avoid emotional decision-making that can lead to "buying more as prices fall."
However, its drawback is that it's not very flexible; for instance, some stocks might experience significant fluctuations where they briefly dip below 5% but then rebound quickly—this could lead you into selling too early.
Therefore, in practice, combining both methods can be effective.
First use technical analysis to estimate where prices are likely to find support before applying capital management techniques for specific stop-loss ratios—for example placing your stop-loss just below the support level with an additional buffer of about 1%—to avoid being adversely affected by short-term volatility when exiting positions.
How Important is Diversification in Investing?
Putting all your eggs in one basket poses a significant risk. Experienced investors know that diversification is crucial for reducing risk.
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What Are the Specific Methods for Diversifying Investments?
Asset Class Diversification
When constructing an investment portfolio, you should diversify across different asset classes.
It’s not enough to invest solely in stocks; you should also include bonds, mutual funds, gold, and other assets.
How should you allocate your investments?
For those with a low-risk tolerance, consider allocating 60% to bonds, 30% to stocks, and 10% to gold. For those with a higher risk appetite, you might increase the stock allocation to 70%, but don’t invest all of it—keeping 30% in bonds and gold adds a layer of safety.
Industry Diversification
In stock investing, it's essential to avoid over-concentration in any single industry.
Different sectors react differently during various economic cycles.
For example, during economic booms, consumer goods and technology sectors usually perform well.
The consumer sector benefits from increased spending power and rising trends in consumption; strong product demand leads to stable company growth.
The technology sector thrives on innovations and breakthroughs that create new markets and drive stock prices up consistently.
On the other hand, industries like pharmaceuticals and utilities tend to be more stable during downturns.
A smart approach is "spreading the exposure": invest across multiple sectors such as technology (for long-term growth potential), consumer goods (to hedge against inflation), pharmaceuticals (for essential needs), and finance (providing a valuation cushion).
If you're optimistic about AI technology, it’s fine to buy tech stocks; just don’t put half your money into them—if policies tighten or outcomes fall short of expectations, a drop in one sector could hurt your entire portfolio.
Geographic Diversification
When A-shares decline, Hong Kong stocks may rise; during U.S. market adjustments, European markets might strengthen.
Investment shouldn’t be confined to domestic markets; consider opportunities globally across different countries and regions.
However, when investing overseas keep in mind factors such as currency fluctuations, political differences, and cultural disparities.
Time Diversification—Avoid Going All In at Once
The main concern with making a large single purchase is "buying at the peak."
A better strategy is to use dollar-cost averaging or phased investment approaches.
Dollar-cost averaging allows you to spread out costs—for example, by regularly investing fixed amounts each month—you can mitigate risks from market volatility that could inflate purchase prices.
Phased investment means if you're positive about a particular stock: start by buying 30% of your desired position; if it drops by 10%, add another 20%; if it falls by 20%, increase another 30%. Keep an additional 20% of funds available for extreme situations—this way you avoid missing out while preventing being fully invested as prices decrease further.
Two Major “Pitfalls” of Diversified Investing to Avoid
Don’t Diversify Just for Diversity's Sake
Owning 100 different stocks isn’t necessarily better than owning ten low-correlated assets.
For instance, bank stocks and insurance stocks tend to be closely related within the financial sector; purchasing both essentially negates diversification efforts.
Combining stocks with bonds or gold—which have a low correlation—can result in effective diversification.
Regularly Review Your Portfolio
Markets change over time just like industries do; hence your asset allocation should also evolve accordingly.
For instance, after witnessing an explosion of interest in AI technologies in 2023, you might want to increase allocations toward tech stocks this year as well as adjust for rising inflationary concerns toward gold investments next year.
Each year take some time for a review: Which assets performed well? Which ones lagged? Consider eliminating positions with worsening fundamentals while shifting funds into areas showing greater potential.
How to Use Hedging Tools?
Futures Hedging—Insurance for Your Stocks
The core idea behind futures hedging is straightforward: use gains from the futures market to offset losses in your stock portfolio.
For example, if you have a stock portfolio worth 1 million yuan and are concerned about a market downturn, you can short corresponding stock index futures.
Suppose the market later drops by 10%, resulting in a loss of 100,000 yuan on your stocks, but your short futures position gains 80,000 yuan.
This means your actual loss would only be 20,000 yuan—like buying discounted insurance for your stocks.
On the flip side, if you plan to buy stocks in three months but fear prices will rise by then, you can buy long contracts in the futures market now to lock in current prices.
For instance, if you intend to purchase 100,000 shares of Stock A at a current price of 50 yuan and worry it may rise to 60 yuan in three months, purchasing futures contracts allows you to secure that price now.
If the price does rise to 60 yuan later on, you'll earn an additional profit of 10 yuan per share from the futures position—this effectively offsets any increase in purchase cost.
Options Hedging—a More Flexible Risk Adjuster
Options hedging is more flexible than futures because it offers you choices.
For example, if you own a stock currently priced at 100 yuan and worry it might fall to 80 yuan, you can pay 5 yuan per share for a put option with a strike price of 90 yuan. If the price drops as expected to 80 yuan, you'll have the right to sell at 90 yuan and gain net profits of (90 -80 -5 = ) 5 yuan per share—effectively capping your loss at just 5 yuan.
Another strategy involves selling call options:
For example, if you hold a stock priced at 100 yuan and expect it to stay below 110 yuan in the short term, you can sell a call option with a strike price of 110 yuan, collecting a premium of 3 yuan.
- If the stock price remains below 110 yuan, the option buyer won’t exercise it, allowing you to keep the 3 yuan premium as pure profit.
- However, if the price rises to 120 yuan, you’ll be obligated to sell the stock at 110 yuan, forfeiting 10 yuan of potential gains. This effectively trades upside potential for upfront premium income.
Note that options are subject to “time decay”: As expiration approaches, the option’s value gradually erodes. If market movements defy your expectations, you risk losing the entire premium.
Arbitrage & Hedging – Profiting from Market Inefficiencies
The key lies in exploiting pricing discrepancies.
1. Cross-Market Arbitrage
For instance, if a stock trades at ¥10 on the A-share market and HK$8 (equivalent to ¥8 after currency conversion) on the Hong Kong market, you could buy it in Hong Kong and simultaneously sell it on the A-share market, pocketing a ¥2 price difference.
This strategy capitalizes on supply-demand imbalances across markets but requires vigilance against exchange rate fluctuations and transaction costs.
2. Cross-Commodity Arbitrage
This takes advantage of discrepancies between related assets. For example, gold and silver prices typically move in tandem. If gold surges 20% while silver only rises 5%, causing their ratio to deviate from historical norms, you might:
- Buy silver ETFs (betting on catch-up growth)
- Consider short-selling gold ETFs (betting on a decrease).
Profit when the ratio reverts to its historical mean.
Critical risk: This strategy demands close monitoring of the assets’ correlation. If the price gap widens further instead of converging, losses may escalate.
