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Risk Management. The First Line of Defense. Introduction IV

Parts one, twothree



One of my main
theses is that risk management is the key to long-term success as a
trader.  As such it's a skill that's best developed as early in your trading career as possible.

But that presents a conflict.  If you are brand new to options, you are spending time learning various strategies and trying to understand at least one of them well enough to make trades.  If you accept my premise about the importance of risk management, then becoming familiar with a given strategy is not enough.  Now there's the additional concern of learning to manage risk.

This doesn't have to
be a problem because there is no urgency, especially when you are making trades in a practice, or paper-trading, account.  You must have a good working knowledge of how to trade your strategy before you can get involved with making other trades to 'fix' a troubled position.  When you feel comfortable using your strategy, that's the time to pay attention to discovering what to do when your plan for the trade is not working as hoped.

When you are ready to monitor and adjust a position gone awry, as with any skill, you cannot expect
to be proficient at the start.  The major advantage of trading without real money on the line is that you can experiment with a variety of risk-reducing adjustments.

This may sound overwhelming, and if you feel that way, it's reasonable to exit trades as your only risk management approach – but only as you gain experience and look for alternatives.  the most important aspect of managing trade risk is recognizing that 'doing nothing' is not going to work over the longer-term.

As a new trader, or
as an
experienced trader who is expanding his/her understanding of trading,
please recognize that trading is similar to many other professions.  Practice improves your skill set;  it makes you a better
decision maker.  By making practice trades, you encounter far more decision-making opportunities than when you trade a real account.  In a practice account, you can trade more positions – as long as you are not overwhelmed and devote sufficient time to manage them properly -and that translates into more education, more experience, and greater confidence in your ability to make a good decision under pressure.  Practice is extremely worthwhile.

If you cannot earn
money with a practice account, then there is no reason to believe you
can do any better with real world trading.  Michael Jordan and Tiger
Woods were not born as stars.  They worked long, hard hours and
practiced. A lot.  No one is expecting you to be the top trader, but if
you want to earn a living, it takes work.  You don't just open and
account, enter some trades and collect the cash.

Thus, if I have
encouraged you to learn about risk management, it's okay to get some
good experience with a paper-trading account.  When a trader comes to
believe that proper risk management is vital for long-term success, then
he/she accepts the notion that there is more to learn than merely buying and selling some options.


Not everyone believes in paper trading.  The primary reason is that it's not real and that no emotions are involved in the decision-making process.  In addition, there's a temptation to make it a game.

I cannot disagree more.  First, the successful trader must learn to control emotions, and if you can make emotionless decisions when it's practice money you may be on your way to doing the same with real money.  If you want to be a
winning trader, you must take paper trading seriously.  You must
concentrate on figuring out how to make good decisions, and not just try something weird on
a whim (you an do that in addition to making serious trades).

Paper-trading will be the focus of a future post.

Not everyone has the talent
to become a champion or an expert.  But in the world of trading, you
must be significantly better than average to survive.  I cannot verify
the accuracy of the statement, but I have heard, and find it easy to
believe, that most people who attempt to become traders never
make any money.  If that's true, you must learn, understand, and
practice to be certain you are way above average.

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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

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"I have many options books and
by far your Rookie’s is the best, most unbiased and no-nonsense
book." 
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Risk Management. The First Line of Defense. Introduction I

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.

To be continued

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New Trader FAQs: Experienced Traders and Market Pros Answer the Questions New Traders Ask Most Frequently

New Trader FAQs contains answers to more than 50 questions provided by knowledgeable sources, including yours truly. These are experienced traders and market professionals.

The complete list of questions

Most of the questions have multiple answers, offering different perspectives for tackling a specific problem.

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