Saturday, February 27, 2010

Thinking About Risk

In the article last weekend, I wrote a little about understanding risk and that got me to thinking how important risk really is to the trader. I consider it to be so important that I devoted much of my first book, "Trade Your Way to Wealth," to understanding risk and showing various ways in which a trader might try to reduce and manage risk. Risk, of course, is everywhere and it is particularly significant in trading the markets.

While seeking profits appeals to our "greed" side, risk awakens our "fear" side in trading. My guess is that many a bad trade has resulted from an initial misunderstanding of or an initial failure to pay attention to risk. Once that risk becomes reality, however, it can go so far as to result in fear and panic. Risk in trading means we can lose something we have. Unfortunately, it seems that sometimes traders fail to realize just how much is really at risk until it is too late.

Suppose we buy 5000 shares of an inexpensive little stock trading at $5 a share. Do we look at it as the $25,000 risk it actually is when we buy it or do we just let that thought pass. Is $25,000 a significant amount to risk? For most it probably is but more often than not I have witnessed traders enter positions like this example with no plan of protection. What if the stock price drops $1? That is a $5,000 loss. So often I have heard traders and investors simply say: "I'm not worried, it'll come back." Maybe it will and maybe it won't, and if it does, when will it come back? We might also want to remember that IF it comes back, that just brings us to even. One of the facts I find most compelling regarding risk of loss is that if a position loses 50%, it must then double (move up 100%) just to get back to even.

As we consider risk it may be worth noting that in the market buying a stock is one of the riskiest things we can do. When we buy a stock our total investment is at risk. Recent history has shown us once again that even formerly great companies can fall to zero. Are there any ways we can reduce the risk of losing our whole investment when we buy a stock? Definitely there are. One way is with the use of orders as described in "Trade Your Way to Wealth." For example, we may have a stop loss order in place or a trailing stop loss. In most situations, such an order is likely to prevent losing everything. It seems unlikely that a stock will drop from $50 to $0 overnight and most stocks that fail seem to give some warnings and while they may descend quickly usually take at least some time to hit absolute bottom. In those circumstances, at least the stop loss may preserve capital.

Another way to attempt to protect an asset is to buy a protective put. A put option is a contract whereby the buyer of the put has the right, but not the obligation, to force someone to buy his stock at a pre-determined price (the strike price) any time before the option expires. To obtain that right the buyer of a put pays a premium. The situation is at least analogous to an insurance policy where the insured (stock owner) pays a premium in order to assure that a loss is limited to the premium plus any deductible. For example, suppose I bought 1000 shares of XYZ at $25 a share late February. I might also buy a protective put, perhaps the Jan 2011 25 put for $2. Now, anytime between now and the third Friday in January of 2011 I can assign my shares of stock (known as exercising my put) and force someone to buy my stock for $25 a share (or exactly what I paid for the stock). Since I bought the puts as well as the shares of stock, my total cost would have been $27 a share ($25 for stock and $2 for put) so I would lose $2 a share if I exercised my puts. Importantly, however, that is the most I could lose between now and next January no matter how low the share price actually went. Even if the stock fell to $1 a share, I could still get my $25. I have reduced my risk from $25 a share to $2 a share. Of course, to profit overall, the stock price would have to exceed $27 a share.

The preceding paragraph suggests a couple of ways a trader might consider in reducing risk of a stock purchase. Another thought that is often espoused is to diversify. There are differing schools of thought regarding diversification and there are many ways to diversify. In my second book, "Smart Investors Money Machine," I write about a number of ways in which traders and investors can create additional streams of income. Strategies like dividend investing and covered call writing are included among many as well as diversification into and investment in other vehicles like bonds, ETFs, annuities, and even reverse mortgages. When we look at diversification into various categories we are spreading risk though there is an argument that all diversification does is make sure you have some losers to set off against winners.

The concept of risk is very wide-ranging in trading. Compare, for example, buying a stock versus buying a call option. When you buy the stock, you own it, when you buy a call option you buy the right to own the stock, but the cost is much less. We may buy a stock at $25 a share, but we may also buy a $25 call (that gives us the right, but not the obligation to buy the stock at that same $25) for $1.50. In each case, our risk is what we paid for the stock or the call. In that setting obviously the risk is much less in terms of dollar outlay when buying the call than in buying the stock. However, a major risk in option buying is that options expire so our call can only have value until whatever we chose as expiration. Also, assuming no change in the price of the stock, the call becomes less and less valuable as time passes until there is no time left.

These thoughts are only intended to invite the reader to seek a greater understanding of risk. In this article I have used just a couple of examples to illustrate some areas in which it might be useful to be risk aware. For those who may want to gain some deeper insights into specific trading and investing risk management, you may want to check out "Smart Investors Money Machine" and "Trade Your Way to Wealth". In "Trade Your Way..." I included a Table showing relative risk among 15 different strategies that are explained in the book along with a number of other comparative elements including relative risk and reward, initial capital required, the time frame, level of monitoring required, and any built-in protection.

Life is risk and as far as I am concerned risks are to be taken. However, it seems only prudent to make ourselves risk aware as much as practical and to make informed personal decisions on whether or how we might go about managing or reducing our trading and investing risks.

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

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To comment on Bill's article click on the "comments" link below.


~ Nona said...

One guideline that you gave me in our tutoring that has proven invaluable is never to buy anything without a clear cut exit in mind. That piece of advice alone has kept me out of positions and, this week, put me in to two different option positions.

In one case, I sold puts. The underlying stock (Royal Bank of Canada -- RY) has climbed upward. In less than a week I could have closed out my position with an almost 40% profit. I'm moving up my exit and holding the position a while longer thanks to another point you made in the tutoring: buying puts with shorter time to expiration. My puts expire in April. Thus, I'll be able to close out my position quite soon and very likely profitably thanks to the combination of deteriorating time value, which will start pressing HARD against the puts pushing down the buy-back price and (I hope!) the upward move of the underlying stock. Unless I see a better opportunity begin to develop, I might even let the puts expire worthless and keep 100% of the premium. That saves another commission.

Likewise, I bought deep in the money calls many months out on Verizon noting that the price of the stock has not gone through resistance for a long, long time. I bought after the stock "flirted" with resistance (again) several times but didn't slice through. My clear-cut sell signal is the bright red resistance line -- another lesson you taught me.

I now look only for opportunities where I can see a clear-cut, unmistakable exit. I also keep position size small, keep alert to sound money management principles (all covered in detail in your first book) and, while I've not made a killing, I am seeing improvement in my trading.

The big step forward for me was spending the money for your tutoring. It took a while for me to internalize the lessons, but little by little they're becoming a bigger part of me. Thank you!

Unknown said...

Well done Mr. Bill,
I'm just a beginner in self education stage, looking to start my own trading but can't yet get enough confidence. The above article of yours was written in a very simple & conceivable language that I guess after several such articles covering the major aspects need to be learned before starting I can start with good confidence.
This is compared to many complex & frequently expensive educational approaches provided by other writers that eventually prove worthless as they make me - at least - fear trading.
Thank you, & I hope I can benefit from your writings more in the future.

~ Nona said...

Having a clear-cut exit is one way to cut risk, IMHO.

But I am interested in a different way of cutting risk when one owns stock: using stops instead of buying puts.

Buying puts is an on-going expense. Using stops is protective -- with limitations, I understand, but still protective. It seems to me that in the long run it's more cost-effective to rely on stops.

I wish I had relied on one or the other a few years ago BUT it still seems to me that the lowest cost protection, overall, is a well-considered put.

I would appreciate your thoughts on this, Bill.

Michael Loren said...

Like Nona's question, I am also concerned about the cost of the protection put. From your book I am appreciating the the issue of risk, especially that of individual stocks. I am leaning toward etf's and the use of stops, which etf's being generally less volatile compared to stocks what type of stops would you recommend: for example BND which is an intermediate bond fund there is very small daily variations, but it is still interest rate sensitive, so I am using a narrow 2% stop. A more variable price etf that is a stock fund I am using a 6 to 8% stop.

Anonymous said...

Mr. Kraft,

This little weekend letter is one of the few in this overhyped world that I throughly enjoy reading. I have read your work and apply the principles and have enjoyed the profitable returns accordingly. Please keep the good work coming. many thanks


Bill Kraft, said...

Congratulations, Nona. I'm really glad to hear that your hard work is paying off. I'm really glad the coaching sessions have helped, but the credit goes to you. As we discussed, it can be simple, but that doesn't mean that trading is easy or doesn't take effort and investment.
Bill Kraft

Bill Kraft, said...

Thanks for writing, Jorge. Confidence comes, in part at least, from knowledge. I'm glad the articles are helping you as you begin. Practice is another important ingredient. Though I recognize that there is a real difference between paper trading and real money trading, I also advocate paper (practice) trading as a way to familiarize oneself with strategies and adjustments.
Bill Kraft

Bill Kraft, said...

Nona asked my views on protection in trading and addressed stops versus puts as one example. As with so many facets of trading, it is an individual decision and inevitably requires some compromise. For example, one may decide (as many investors do) to have no protection whatsoever. They are completely at risk. Others may want the assurance afforded by the purchase of puts, but, of course, puts come at a cost just like an insurance policy. Stops fall in between and ordinarily afford the ability to get out of a position that is going the wrong way but include the risk that one may not get the price one wants in the event of a gap over the stop. However, they do have the positive that there is no cost to place or modify the order at least with brokers I use and they do get the investor out of the position based upon some negative movement albeit maybe with a larger loss than anticipated, but at least by cutting a loss promptly.
Bill Kraft

Bill Kraft, said...

Dave, thank you for your kind comments. I really appreciate it.
Bill Kraft