Sovereign debt, falling gold prices, Euro worries… there is a lot of talk in the news about risk. However, as a trader/investor, risk can mean something different. There are two types of risk we must face in the markets. The first is considered an opportunity, as seen in the current risk issues facing the global markets that I highlighted above. This risk in the world makes for increased volatility that we can profit from. The second risk we face is the risk of loss in our positions. In fact, when we are trading or investing, the amount of loss we will suffer is the only thing we can control. We cannot control whether we will win or lose in the position as we cannot control the direction of the markets themselves.
To most traders, risk management means simply setting stops. Many investors do not even do this to control risk. However there is much more to managing your risk in the markets. You wouldn’t drive onto a bridge if you have noticed that most of the supports have crumbled would you? Would you walk onto a frozen lake after seeing a “Thin Ice” sign posted and several cracks showing in the ice itself? Of course you wouldn’t, that is because you observed the environment and realized that it was too risky to proceed.
We need to observe the same discipline when we are involved in the financial markets. To analyze risk before trading or investing, we must look at the current market environment, the security’s environment, and the trend. Are we in a danger spot that would preclude us from taking a trade? No one is forcing us to enter into every trade that we see. Suppose the markets were bearish, your security has just released disappointing earnings, and is near resistance on your trading and larger timeframes. Would you buy shares just because prices moved up slightly after a bullish hammer candle? Most likely you wouldn’t. Even though you have a short term bullish signal, the overwhelming bearishness of the markets tells you that the environment is risky for a long and the reward isn’t large enough to endorse a long position.
We need to mimic the most successful traders/investors in the equities markets, the brokers. The brokerages have a separate department called compliance to analyze risk and ensure the brokers and traders are staying within guidelines set forth by the broker and regulation. As an individual trader/investor, you are the trading desk and the compliance desk, and you must perform both of these functions to be successful in the markets. Many people can plan a trade, but not all have the ability to analyze the risk and manage the risk in a manner that ensures their financial survival in the markets when things go wrong. And believe me, they will from time to time.
You may remember the older radios with analog dials on them. Before digital came into our lives, we had to adjust radio stations and volume by turning the knob. Well the risk radio works similarly. On this radio we have three knobs that we can adjust to increase or reduce the risk we face when trading the markets. Only by finding the right balance will we trade to the best of our abilities.
The first knob is similar to one we would find on a normal radio, frequency. In trading, frequency refers to the number of positions we will open. The issue with many traders/investors is that they will keep this knob turned up way too high and take trades with only a marginal chance for success. They do this due to fear of missing opportunity and profits in the markets. Successful traders/investors have the discipline to turn down the frequency and take only those trades that meet specific criteria outlined in their plan and offer a high probability for profits. As a new trader/investor, you should limit the number of trades you take per day/week/month. This will force you to look for the right opportunities to trade rather than jumping in on any small move in the markets. Remember, even if you miss an opportunity, there is another one coming along very soon.
The second knob is duration, or the amount of time spent in the position. The longer you spend in a position, the greater the chance for adverse price movement. This is why investors take on much greater risk in the markets than traders do. When we turn down the knob to smaller timeframes, we have less profit potential but also much less risk. Think about what can happen to a stock position over the course of an hour. Then imagine what could happen to that same position if you were to hold it overnight, or even over the weekend, what about for a year? Right, you are exposed to potential gapping against you and have little to no protection. Trading on smaller timeframes reduces the risk we face in our trades.
This knob should also be turned down when overall volatility in the markets rise. Rising volatility causes more drastic price swings. As a new trader who is unaccustomed to trading these swings, you are best served by reducing your exposure to them by trading in smaller blocks.
This leads us to discuss the most important risk control knob, volume. Volume for a trader/investor is the share size we are taking per position. Obviously, most people want to profit as much as possible, but by taking larger share size, we are also increasing our risks. Volume should start at demo, with no money at risk. After successfully practicing you may increase your risk with minimal shares. If you keep doing well, gradually increase your share size.
The key word in the last sentence is gradually. Many traders feel they must go from 100 to 1000 shares, or 1000 to 10000 shares. This increases your risk ten times! You are much better off by no more than doubling your share size or risk for every step and only do so if you are achieving a positive win/loss ratio. When you risk more money in a position, there is a psychological effect that you will notice. Watching profits and losses increase exponentially can wreak havoc on new trader’s psyche. This may cause you to panic and exit positions too soon or to hold onto losers as you become frozen with fear.
If you are not trading or investing well at any time, you should immediately tune the trader’s risk radio. First reach for the volume and reduce your share size. Secondly, be more selective in your positions and turn down the frequency. Lastly, you can also reduce the duration of trades to offset volatility. Tuning the risk radio correctly will ensure that your money plays a happy tune you will love to sing along to!