I recently posted a (very) short course on risk management. After due consideration, I decided that this aspect of trading is so important that it's worthy of a much more detailed discussion. For anyone who trades with 'guts' or 'feel' or by the seat of his/her pants, you may believe this is an unnecessary discussion. If you talk to successful traders, you will discover that almost every one of them will tell you that risk management is essential to long-term success. I'll go further than that: If you are neither a skillful risk manager nor a very lucky trader, your trading career is not likely to last a long time if you are unaware of, and thus, ignore, risk.
That's the rationale behind this series of posts which continues the discussion, in depth. As I write, I don't know where this is going, but I know where to begin. At the beginning.
This gives me the opportunity to write about my philosophy of trading. I've developed some ideas over the past 33 years of trading options. Some are universally accepted – which means I didn't really develop them, I borrowed them. Other ideas represent my point of view, which in turn, came from my experience as a trader. Risk management ideas from this perspective should be useful because it offers detailed suggestions as well as specific guidelines. [Some of these ideas are presented in Lessons of a Lifetime, my recent e-book]
I encourage you to think about the suggestions made here. This is not physics or chemistry in which someone can lay out the laws that have been proven to be accurate by experimentation and testing. I offer ideas that seem logical to me. They represent the truth as I see it. However, the advantage for you is that you can think about these ideas, try them, modify them, and then you may elect to disagree with them. It's real life science in which you experiment with an idea, and then adopt it or reject it as you develop your own theories about how best to manage risk.
My task is to see that you come to recognize the importance of risk management and to get you thinking in a manner that will serve you well. Your task is to ask questions, think about what you are doing, and not blindly accept every suggestion being made.
Learning to pay due respect to risk is easy once you get clobbered a time or two. I'm suggesting you save yourself that ordeal by taking risk and money management as essential parts of trading.
Learning to limit risk (at all times) is similar to learning about, and choosing a specific option strategy to trade. Successful traders don't adopt a single trading idea (strategy) and use it forever. Different market conditions are far more friendly to certain strategies (and a strategy is merely selecting which options to buy and sell to form a position) than others. As conditions change, the intelligent trader is flexible enough (i.e., not stubbornly adhering to a method that is clearly not working) to select alternative strategies and reduce position size. Similarly there are many ideas you can put into play when keeping risk under control.
I recently asked a well-respected trading coach whether I was over-emphasizing risk management to the beginner, wondering whether it would be better to allow that rookie to gain some experience before making the effort to understand why risk management is so important. The reply was 'no' – I was not overstating the importance of risk management. In fact, he told me that the rookies' trading career would likely be very short if he/she did not get on board with managing risk almost from the start of trading.
The truth: I enjoy writing instructive posts, but I'm not writing for myself. I want to help you learn to use options profitably. I want you to avoid mistakes I made – and believe me, ignoring the importance of managing risk is at the top of the list of my trading sins. If I can help you steer a smooth course through the jungles of trading, then your life will be a lot less stressful, and happier. With that purpose in mind, I'm beginning a detailed foray into the world of risk management.
This is not going to be a mathematical treatise. Indeed, it's not only targeted to rookie option traders, but also to anyone else who has not paid enough attention to managing the risk of owning option positions. And for those who do have a decent understanding of how to keep risk in line, there should still be useful tips. With that in mind, let's get started.
There is much ground to be covered, so please have patience.
New Trader FAQs contains answers to more than 50 questions provided by knowledgeable sources, including yours truly. These are experienced traders and market professionals.
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Most of the questions have multiple answers, offering different perspectives for tackling a specific problem.