Saturday, December 15, 2007

Understanding Risk Can Improve Your Trading

After last weekend's article about day trading and the perils about which the NASD warns prospective day traders, I received some contributions to the blog from a couple of apparently successful day traders. Their contributions demonstrate that some traders can and do make money day trading. Does that mean we should ignore the NASD's warnings? No, of course we should be aware of the pitfalls of any strategy we are considering or using. No strategy is perfect. The "buy and hold" strategy, for example, has pitfalls as well. Does that mean a "buy and hold" investor can't make money? Of course not; it only means that the "buy and hold" investor needs to be aware of a set of risks that pertain to the particular strategy.

One issue that day traders face is the necessity to overcome the costs of trading. If a day trader enters 3 positions a day on the average, by definition he will be closing those same positions the same day. If he pays a $9 commission to enter and a $9 commission to exit, that is $54 a day in commissions and if he trades 250 days a year, he should know he must realize gains of at least $13,500 a year just to pay the commissions. The buy and hold investor, in all probability, does not face the same commission hurdle in a given year, but he may expose himself to very large losses if a stock or market retraces. Either strategy can make or lose money; it is important to know where the risks are and what is really at risk.

When someone buys a stock, what is the risk? It is the price of the stock since it could literally fall to zero. If a trader buys an option, what is the risk? It is the price of the option which will almost always be less than the price of the stock. If that is so, and it is, why not just buy options instead of stock? What other risks does the option buyer face? The ultimate risk is the price of the option, but the option buyer also has an enemy in the passage of time since options expire. The time value of an option is constantly running against the option buyer (and in favor of the option seller) so, in order to profit from the purchase of an option, the option buyer must have a move, the move should be in the right direction, and the move needs to happen relatively quickly, certainly before the option expires. Does that mean option buyers can't achieve profits? No, it only means that the option buyer needs to make trading decisions with these factors in mind and, the decisions should be made before a trade is ever entered.

In my years of trading and of teaching trading, I have observed that many traders, particularly those who do not achieve success, fail to understand and appreciate the risks inherent in the strategies they employ. When I was asked to write my book, "Trade Your Way to Wealth: Earn Big Profits with No-Risk, Low-Risk, and Measured-Risk Strategies," I decided to write not only about some very profitable strategies, but also to examine the risks inherent in each of those strategies. One of the primary groups for whom I wrote are those approaching retirement who for one reason or another are afraid they will outlive their money or will have to rein in their quality of life. Those people including so many baby-boomers may also fear trading because they are concerned about losing their money. A little information (and I include it in the book) can help reduce those fears if the prospective trader will learn how a "no-risk" trade can be constructed or how a relatively low-risk position can be traded while providing substantial income (sometimes even tax free) at the same time. The book is scheduled for release in mid-January and is now available on pre-release at amazon.com.

For those of you who may be interested, I will be speaking on some of those same subjects at the New York Trader's Expo at the Marriott Marquis in New York City during the Expo from February 16th to 19th, 2008. I believe the Expo is free and you can check it out by googling New York Traders Expo if you are interested in furthering your trading knowledge at that popular event. I hope to see you there and I'd be glad to sign a book if you would like.

Enough digression, but as the regular readers know, I am a real believer in continuing trader education. Perhaps the most important result of the education is to know oneself better. Knowing oneself better, includes learning where your personal risk tolerance really is, learning what strategies fit your trading personality, and learning how you can best remove emotions in your own trading. Removal of emotion may come only with an insured or "no-risk" trade for some, but others may be able to sufficiently discipline themselves to seek higher returns with higher risk strategies. Keep in mind that there are many ways to profit in the market and we may each choose a different path to that success. First, though, we need to figure out what path suits our risk tolerance, our personality, our money management strategy and, very importantly, lets us sleep soundly at night.

by Bill Kraft, Editor
Copyright 2007, Makin' Hay, Inc.
All Rights Reserved


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3 comments:

S said...

Any trader that uses a broker charging $9 per trade deserves the problem.
Why not use IB which charges $1 per trade and only 46 cents for a single stock future on a stock.

Bill Kraft, MarketFN.com said...

Thanks for writing, S. There are many reasons to choose a broker other than commission though commission rate is among the criteria. Consistently good fills, for example, can often outweigh cheaper commissions. Sometimes newer traders may need someone to lean on so they might want to use an experienced helpful (difficult to find) full service broker. Like most areas of trading, it comes down to the knowledge, experience, and discipline of the trader that really counts.

george said...

The transaction cost mentioned in your blog is for longer-term amateur traders only. For retail day traders, half penny per share (5 bucks for 1000 shares) is the norm. As for professional day traders, not only that they pay much less than that amount (some pay as small as 20 cents per 1000 shares), but also get the ECN fee rebates. Some day traders even make money from their trading transactions while the price of the stocks hardly moved. Nowadays, only the academics would think that transaction costs make day trading a loser's game.