The Importance of Risk Management
By Joel Addison, Optionetics.com
01/25/2001 5:00:00 PM
Risk: The possibility of loss.
Manage: To handle or direct with a degree of skill.
When we refer to risk management, we speak of the ability to handle with a degree of skill our possibility of loss. Of course, when dealing with trading and the market, there are many kinds of risks. Overall, what we are trying to do is make money while at the same time managing our possibility of loss. This definition could be considered the Optionetics motto.
Risk management isn't the sexiest of terms; people don't run out and study everything they can on the subject when they hear it. This has to do with the fact that risk management often discusses how to avoid losses, not how to make huge returns. Newsletters and stock-picking sites post claims of high returns on individual plays, but rarely state they controlled their losses with proper risk management. It just doesn't sell. Baseball has taught us that people prefer a homerun to four straight base hits; but a knowledgeable coach or trader knows that it's the base hits that win games-not the homeruns.
Everyone wants to talk about the option play that made him or her 1000%. But does this same person tell you about the other five plays that they lost everything on? Of course they don't. Does risk management mean you can't make large returns on your money? No, it does not. It means avoiding risks that do not make sense over the long term. Maybe the most common reason why option traders don't last long is because they take too many risks. Even though they win occasionally, they end up running out of capital before the next home run is hit. Once you are down 5-0 in the 9th inning, that one homerun is not going to win the game for you.
I believe one of the most important things to understand is compound interest. Most of us profess to understand this concept; but if we did, we wouldn't be so quick to take the risks we often do. Let me explain this with an example.
If I put $1,000 in a trade and it returns 1000%, I now have $10,000. Now that I have this extra capital, I decide to place $2,500 in four different trades, but each of these loses 50% of their value. I now have $5,000 left. On the other hand, if I made just a 50% profit on each trade and compounded this growth each time, I would have over $11,000. This is because of the compounding effect on my money. This is a very rough example. Obviously, taking all your winnings and playing it on one trade is not advised; but the point is that smaller profits that are compounded will create a larger account than risking too much to hit the homerun. When was the last time you got a 1000% return anyway? In order to this, too much risk is normally taken.
Optionetics teaches us that hedging ourselves in case of a loss is as important as getting out with a profit. None of us want to entertain the thought that we might be wrong about a trade; but the fact is we will be wrong some time and we need to be prepared for that event. On every trade we place, we should figure what our risk/reward is. If we are risking $500 to make $100, is that a good risk/reward? In general, the answer would be no. However, it really depends on the probability that the $100 would be made and the $500 would be lost. For example, what if you see an option trade that has a risk of $500, but this only occurs if a stock at 50 drops all the way to 35 in the next two weeks. The odds would probably say this risk is worth the reward because this drop is not likely to happen. This same philosophy holds true when looking at risk/reward of let's say 10-1. This looks great, but if the stock needs to move 75% in a month to get this reward, is it really a good risk?
Clearly, there is a lot to risk management. The underlying theme is to make certain you analyze the relationship between risk and reward. Understand that taking fewer risks and not holding on for the homerun will benefit each of you in the long run. Optionetics.com's Platinum site has tools to help traders figure probabilities and risk/reward ratios that can make better traders of us all.
So before you start visualizing that new car from the profits of one trade, actually analyze the situation and make sure it really is the best move to make. |
