Friday, February 19, 2010

Importance of Risk

Over the last couple of weekends, I wrote about prioritizing trading skills and a subscriber emailed to emphasize the issue of risk. Probably nothing is more important than the concept of and issues surrounding risk. In fact, I wrote "Trade Your Way to Wealth" with the specific purpose of addressing risk awareness and risk management. In the book, I discuss a number of ways to manage and reduce risk because I am convinced that all too many traders and investors either fail to understand or at least fail to pay attention to the risk attendant to their trading.

Trading is risky, and it is even riskier if the trader fails to appreciate just what risk he is taking. Buying a stock, quite simply, is a high risk proposition. The whole investment is at risk unless some hedge is also employed. Over the years I've heard investors say things like: "Yes, owning stock may be risky, but I have shares in a good company so I really don't have that much risk." Unfortunately, as so many have learned the hard way, that just isn't necessarily so.

As an example, a couple of years ago when Citigroup (C) was trading near $40 a subscriber took me to task when I reiterated that I believed buy and hold was a dangerous strategy (when there was no exit plan). He wrote telling me he should be writing these articles and I didn't know what I was talking about since he and his family held Citigroup (C) (which he referred to as "that old doggie") since it was trading around $14. Quite an accomplishment now that the stock has not traded above $5.50 since early 2009. All we need consider is the disappearance of once great companies like Lehman Bros. or Washington Mutual. The list of once good companies that have since disappeared is shockingly long.

Most, if not all, of the priorities I discussed in the last two articles are specifically related to management of risk. Consider, for example, entry decisions and strategies. I personally use an entry strategy that attempts to assure my initial exit is nearby in the event I am wrong on direction. In other words, part of my plan recognizes that I can be wrong and if I am I have an exit strategy that helps reduce risk by cutting losses quickly. So, too, do principles like money management, reward to risk ratios, pre-planning a trade, and knowledge of types and uses of orders help manage my risk. If I am not utilizing such skills I am opening myself to greater risk. While risk can rarely be removed completely, we can and should take sensible measures to manage and alleviate the risks of our trading.

Once again, it comes down to our trading education. Unless we know, for example, what a protective put is and how it works, we don't know how to use it to reduce our risk. As a parting word this weekend, consider, if you will, what is more dangerous in the stock market than simply buying a stock? Is selling a naked put more dangerous than buying a stock? How about buying a call on the stock? How does the risk of owning a stock change if you also sell a covered call or buy a protective put? All these strategies and many others can be used to manage risk as long as we know what they are and how to use them. I cover these concepts in "Trade Your Way to Wealth," but the information can be found many other places as well. It makes sense to know the answers ahead of time.

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved

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Anonymous said...

I enjoy all the week end very informative letters. I would like to comment on some strategies recommended.
Regarding the strategies Straddle and Strangles explained on the book Trade your Way to Wealth I would like to know how I realize gains. What I interpret for instance in the straddle strategy both the calls and puts are purchased at the money and if the call increases in value the put
decreases in value almost equally cancelling the gains. Question, to
insure keeping the gains do I sell the puts inmediatly after there is a strong signal that the calls will continue to increase in value?
I would appreciate your help on this strategy.
Thank you. . . . .Armando Tavian

Bill Kraft, said...

Armando, sorry for the delay in responding. The first answer to your question about trading straddles is that the delta changes differently on the calls and puts as movement occurs in a straddle. For example, suppose a stock is moving up in price with plenty of time until the options expire. As the call gets further and further in the money, the delta gets higher and higher until it eventually approaches 1. As the call delta is increasing and the calls become more and more valuable with the upward move, the delta of the put decreases so less is being lost on the put side than is being made on the call side and, of course, the value of the puts can only go to zero and not below while the calls have a theoretically unlimited upside. The management of the trade is dependent upon the individual and can range from holding both legs until expiration to legging in and out actively depending upon stock price movement.
Bill Kraft