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Activity on online trading platforms continues to trend upwards as retail investors who are passionate about making money from the markets increasingly take a do-it-yourself (DIY) or self-directed approach in how they express their personal views and investment flair with the discretionary portion – usually 5-10% – of their investment portfolios.

 

Provided investors have ticked the requisite boxes, with a comprehensive savings and investment plan in place that caters adequately for retirement, with sufficient allocations to longer-term savings through a pension fund or RA, and access to liquidity – between 3-6 months of living expenses – for emergencies, they can allocate a percentage of or the entire discretionary portion to executing a trading strategy.

Investors should view the trading portion of their portfolio as an income stream rather than a long-term investment. Trading generally involves speculating on financial market movements and changes in asset prices over shorter timelines, typically hours, days or weeks, to capitalise on transient or emerging market or economic trends.

Trading platforms allow investors to get their share of local and global markets with simple, efficient, and cost-effective frictionless access to a broad opportunity set across various sectors and geographies, with the option to trade numerous assets, including stocks and foreign currencies.

By providing frictionless access to global markets, trading platforms allow investors to diversify in ways not previously possible from SA-only market exposure, providing foreign exposure to the world’s biggest companies and powerful themes and trends like technology and AI.

Traders can also access a diverse range of asset classes online through ETFs, which offer broad market exposure across different themes and baskets, without the need to take a specific stock view for an easier way to diversify a portfolio.

As online trading platform development has matured, providers have also made additional tools and instruments available for investors to implement more advanced and technical trading strategies, with options to use the power of leverage to trade with margin.

Using leverage to trade with margin creates the potential to generate higher returns for investors as they can invest more than their available personal funds.

Margin trading also supports short-selling, which opens up additional opportunities and greater flexibility for astute and experienced investors to generate a profit from market movements or changes in the prices of stocks or currencies in either direction.

However, while using leverage to trade on margin can amplify potential returns, it can also magnify any potential losses, which makes margin trading a high-risk, high-reward activity.

When constructing potential trades, traders need to determine what types of trading interest them and suit their capital allocation. They can then apply a top-down analysis and conduct in-depth research to identify broader opportunities within those sectors or markets before selecting individual trades or trading styles, like a momentum trade or a pure technical analysis trade.

The next step is calculating the risk-reward ratio in each trade as part of an overarching risk management strategy. The ultimate risk-reward ratio in any trade is strategy-dependent. 

Traders with more conviction may choose to lower the ratio by increasing their exposure on a specific trade that they believe has a higher probability of success, or conversely, on a trade with a low probability of success but a high potential return, like a Black Swan event that could deliver 10x returns.

Traders who opt to embrace shorter-term trading strategies that aim to make a 1-2% profit on each trade would require a higher ratio to ensure that overall returns exceed total losses. There is no universal risk-reward ratio that applies to all trades in isolation, and the approach applies to trades executed with or without margin.

Another key risk management consideration in any trading strategy is position sizing, which helps traders determine the appropriate number of shares to buy or sell in a particular trade based on an identified entry price while establishing a stop-loss exit point that defines and controls how much capital a trader could potentially lose on the trade.

The difference between these values indicates the capital a trader is ultimately risking, which should align with their risk tolerance – the total amount a trader is comfortable with and can afford to potentially lose on a single trade. This housekeeping is about prudent money management.

The industry norm is to risk 2-3% relative to the portfolio size of a single trade. Whatever position a trader takes, it is important to understand the proportion of the portfolio they are risking on each trade.

Based on this risk tolerance, traders should implement risk-mitigation measures to protect themselves from downside risks by putting stop-loss orders in place that automatically buy or sell a security if the price reaches the identified threshold to limit potential losses.

Ultimately, the critical success factor in any risk mitigation strategy is meticulously planning every trade and then trading the plan. Traders need to adhere to the strategy and stick to their defined entry and exit points by keeping their emotions out of the decision-making process to avoid mistakes like averaging down by adding to a losing position, hoping the price will rebound.

In this regard, it is critical that a trader determines their risk tolerance, which relates to their financial and psychological ability to handle large potential drawdowns on capital. An ability to adhere to the plan and control emotions informs each trading strategy, helping to define critical elements related to the risk-reward ratio and position size of each trade.

In the end, traders who are passionate about the process, have a clear goal, take the time to understand markets, and learn from their trades by keeping meticulous notes will develop the acumen and track record needed to succeed. DM/BM

By Tinus Rautenbach, Business Head of Clarity, by Investec

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