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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