Understanding Risk: The Hallmark of a Good Trader
Patterns for Profits Newsletter - October 3, 2007
Risk. It's a part of everything you do. Driving to the office, going to the mall or just getting out of bed in the morning; each has a certain amount of risk involved. The key to life is accomplishing what you want while being careful at the same time; this is a definition of risk management. This applies to investing in the stock market or options trading as well. While there may be “short-cuts” to accumulating wealth, the hallmark of a good trader is to understand the inherent risks involved and create an investment plan that reduces them.
The Elements of Risk Management
There are several different components in risk management. These elements include:
- Identifying risk before it occurs
- Evaluating risk when it happens
- The strategies for reducing risk
Each of these is an important part of the overall process of making money and keeping it, so let's discuss these components.
Identifying Risk Before it Occurs
Your research tells you that now is a good time to invest in gold because the charts show some short-term instability before returning to its trend. You know that it will return to an upward trend in the future but you stand to make some good money now. You’ve identified the volatility risk and you know exactly what to do. You implement a risk management strategy by options trading. You can either buy an out-of-the-money option believing that the price will eventually climb or an in-the-money option because you know during this time of instability the price is going to drop before rising again. These are two different strategies...how can both types of options trading be used in risk management?
There are a lot of methods of risk management and these are just two. Options trading is a great risk management strategy. Buying an out-of-the-money option on something you know gives you an opportunity to profit as the commodity returns to its trend. If it doesn’t, you simply let the option expire and you’ve only lost your premium on the deal. Conversely, buying the in-the-money option during the instability allows you to speculate that the commodity, gold in this case, will drop before returning to its upward trend. If it drops, you take the profit; if it doesn’t drop, you still walk away from the contract. That’s the beauty of risk management in options trading.
Evaluating Risk When it Happens
Maybe you don’t have an options trading contract on a commodity; instead you are holding a futures contract for wheat, expecting the price to rise. Instead of rising, the price is falling and you stand to lose a lot of money. What should you do? First of all, don’t panic! There is movement in commodity prices every day, so step back, take a deep breath and do some research.
The hallmark of a good trader is understanding risk. Make sure where you stand BEFORE you go into any kind of risk management strategy. Don’t rush out and do any options trading to offset your futures contract; don’t listen to the TV news. Answer one question...what does YOUR research say? If a well-defined problem is nearly solved, then a risk that is understood is nearly averted. Sometimes the best risk management is simply knowing where you actually stand in a particular position before you act.
The Strategies for Reducing Risk
The final element in risk management is knowing what to do when there really is risk. Like our options trading example, understanding the risk with a losing option might be nothing more than letting an options trading contract expire. You lost the premium on the contract but nothing else. (That’s one reason why options trading can really be your friend.) Options trading gives you the right, not the responsibility, to accept a particular contract; this makes it a great tool in risk management.
Risk Management – Not Only About Options Trading
While it is true that options trading is a great way to reduce risk, it is not the only way. You need to learn stop loss strategies if you are serious about being a successful investor. Learning how and when to exit a trade is crucial. Options trading is one way, but there are others you need to learn.
Risk management is the product of identifying risk before it occurs, evaluating it when it does and finally reducing the risk. Understanding your risk, and being able to act on it, is the hallmark of a good trader.
Understanding Risk: The Hallmark of a Successful Trader
By Kelly Hill
It is all too easy in trading to focus on how much you can make opposed to how much you can lose. If you are a new trader, I recommend that you evaluate how much of your time and energy you are spending on downside protection as opposed to profit potential.
A speculator is someone who analyzes the downside, the level of risk, and probability of loss for the return, and then decides whether to take action. A gambler is someone who either doesn't understand the risk for the return, or just as likely chooses to ignore it.
The media, books, news, the industry, etc. generally focus on how much you can make. That is what sells! All too often we are encountered with typical headlines of “ Joe Trader just made one gazillion dollars in 6 days trading orange juice .” ,whether it came in the mailbox, on television or in a book that you read. It can be distracting to the committed trader learning the craft and damaging in shifting their focus from proper trade management to “swinging for the fence” mentality in going for long shot winning returns. I admit concentrating on the upside is far more enjoyable than watching the downside. However, the stories of rags to riches, uplifting as they may be, can distort reality for a new learning trader.
The long term successful trader is one who is constantly watching the downside not only in proper sizing based upon their account capital, but also by sticking to their trade plan and staying out of low probability chances.
Patterns for Profits Trading Tips
Here is a list of questions that will assist in keeping a newer or struggling trader from getting sidetracked.
For any particular trade:
- What is the risk to return?
- How probable is the return for the level of risk?
- Do I have a proper stop loss in place when I enter a trade?
- Does my written trade plan have a proven method of managing stop losses on trades that are going my way?
- Am I willing to accept this level of risk for the return?
Only through addressing professional questions like these will a trader be able to not only survive in the long run, but actually thrive!
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Leslie Jouflas
Kelly Hill
8325 East Pheasant Hill Lane,