Risk Management. The First Line of Defense. Introduction II

Part I

What is money
management? What is risk management? It's important to agree on the definition of the topics
under discussion.

 

Money
Management

Here is a good,
basic definition from Wikipedia:        
Money-management

Money management
deals with the question of how much risk a decision maker should take in
situations where uncertainty is present

More precisely
what percentage or what part of the decision maker's wealth should be
put at risk in order to maximize the decision maker's potential

Money management
gives practical advice to gamblers and stock traders

A good
understanding of money management minimizes the Risk
of Ruin
, or the possibility of losing your entire trading account

The key to
successful money management is maximizing every winning trade and
minimizing losses


Thus, the takeaway
for us, as option traders is:

Trade size is a
very important decision (how much to place at risk)

Minimizing losses
is essential (do not stubbornly allow losses to grow)

Maximizing gains
is a big part of the game (but do not ignore risk when seeking that
maximum)

 

This last part –
about maximizing gains – presents the trader with difficult decisions.
To maximize profits, you must milk the trade for every last penny
possible. But that's in direct contradiction with the concept of not
risking a lot to earn a little.

Assume a position has
worked well, and you earned almost the maximum possible profit. How can
it be sound policy to hold the position in an attempt to earn another
nickel or dime? To maximize profits you may automatically assume that it's the right decision to go after that last increment and allow all short options to expire worthless.  That's not true. The term 'maximize profits' does not tell you to ignore risk.  It refers to the concept of seeking additional profits from good trades – but only when the current position is worth holding.  Often risk is too large, reward is too small, and the best decision is to exit.

For example, when the maximum reward is
$10 and, although you are unlikely to lose the maximum (perhaps $500 or
$1,000), most of those profits can disappear while waiting to milk the
trade for just a bit more profit.

I don't believe in taking
that risk. I believe in exiting a winning trade when the potential
profit is very small compared with what can be lost in an unexpected
event.

Here's one area where some readers will disagree with me – before we even
get started.  If your belief is that being too cautious is unwise, and if your comfort zone allows you to seek out additional profits and that the risk is acceptable, I cannot argue.  The borders of your individual comfort zone are yours to define. My task is to encourage you to define that zone.

I'll continue
to pay a small price to exit the trade. Peace of mind has
psychological value, and I'm willing to pay a small insurance premium
to gain that tranquility.  Trading psychology is a topic that will
reappear in this series.

 

Risk Management

This term is more
flexible and there are many perspectives from which to consider the idea
of risk management. Our concern is to define the term as it applies to
placing money at risk with the goal of earning an acceptable return on
an investment. Wikipedia again
offers some very wordy, but descriptive definitions:

a) The
identification, assessment, and prioritization of the effect of
uncertainty on your objectives – followed by coordinated and economical
application of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events or to maximize the
realization of opportunities

b) The process of
determining the maximum acceptable level of overall risk to and from a
proposed activity, then using risk assessment techniques to determine
the initial level of risk and, if this is excessive, developing a
strategy to ameliorate appropriate individual risks until the overall
level of risk is reduced to an acceptable level.

In fewer words,
find the risk, measure it, reduce it when necessary.

I believe this
simple definition is all we need: A discipline for dealing with the
possibility that the future may be surprisingly different from what we
expect.

When investing
money, there is always risk of loss. You must find a way to deal with
the unexpected, so that no single loss is so large that it threatens
your viability as a trader.

At one end of the
risk management spectrum comes the point of view that we can ignore the
unexpected. If it happens you can deal with it at the appropriate time.
This method, if you can call it that, is bravado. But to me, it's really
ignorance. The unexpected, by definition, doesn't refer to 'never.'  In
2008-9 the markets demonstrated that statistically unlikely events can
occur frequently. 

We all own fire and auto insurance, just in case it's
needed. The potential loss resulting from the destruction of your home
or a liability lawsuit resulting from a car accident is devastating. We
all buy protection against the unlikely possibility of needing that
insurance. Managing risk when investing is similar. There are two basic
alternatives: Hedge (or own insurance) or limit the size of the original
investment so that the worst case scenario results in an affordable
loss.

At the other end
of the spectrum is the ultra conservative investor (not likely to be a
trader) who seeks safety above all else. Profits are a secondary
consideration. To this person, risk management and preservation of
capital are the only parts of the game that matter. This investor owns
very secure, high grade investments or hedges his/her portfolio.

To be continued

680



RookiesCover


"I have many options books and
by far your Rookie’s is the best, most unbiased and no-nonsense
book." 
JSY

, , ,

4 Responses to Risk Management. The First Line of Defense. Introduction II

  1. Donald W. 05/04/2010 at 11:04 AM #

    I think what I might not fully understand on Risk Management is exactly what types of hedge is needed. For example: On my Cash secured puts..what is a good hedge, is it buying long puts and when? When the market starts in the other direction or when selling the Puts? What type of hedge with what type of trade?

  2. Mark Wolfinger 05/04/2010 at 11:25 AM #

    Donald,
    Simple question.
    Complex reply.
    I’ll get to this Monday, May 10, 2010

  3. J 05/04/2010 at 5:39 PM #

    Hey Mark,
    This is kind of off topic but do you know of any strategies or recommended ways to reduce taxes on option income from writing covered calls in taxable accounts?
    PS – I echo JSY comments concerning Rookies book. Real info vs fluff.

  4. Mark Wolfinger 05/04/2010 at 10:57 PM #

    Thanks J,
    I don’t. Perhaps someone else can help with an answer.
    Sorry