The following quote about risk taking is not as trivial as it seems. It’s an important concept. By Eric Falkenstein from his falkenblog.
Don’t expect to make more money for taking risk, just know you have to take risk to make more money. If you don’t understand the difference, you shouldn’t be taking risk.
I frequently discuss the fact that to earn higher rewards it’s necessary to either be a very skilled trader, or to take more risk. And I let it go with no further discussion. However, Eric points out the extra ingredient that was missing from any of my earlier discussions. The fact that extra risk is taken does not guarantee any extra reward. In fact there may be no reward.
It’s very possible for the given trader to be in over his/her head with more risk than the trader can handle. And the sad part about that is that it is not immediately obvious. A trader can adopt a new strategy or trading style successfully, without recognizing the extra risk. Until that day when the risk makes itself obvious and it is too late for the trader to recognize that he/she should have been prepared for the possibility that just occurred in the real world.
If you are going to take added risk, that risk must be understood. In many cases, a look at the greeks or a glimpse of the risk graph does not paint the whole picture.
As Eric says – you may want to make more money – and that usually requires taking additional risk But do not believe that simply trading riskier positions (such as trading bigger size) is the path to those profits. Often, that extra size creates situations that frighten the trader into panic mode because the amount of money at risk suddenly overwhelms the trader, if and when the unexpected occurs. Please don’t add risk to your trading before being certain that you are prepared to handle that risk. It’s acceptable to make a bit less money when you can do it without facing a situation that is psychologically too difficult.
The Risk Premium
Definition: The reward for holding a risky investment rather than one that is risk-free. Alternatively, it is the minimum anticipated return required to entice the investor to own the more risky position.
We all recognize that options trading involves some risk (the super-risk adverse, computer-assisted, traders can neutralize their positions efficiently). One problem is that it is difficult to describe the specific risk for a specific strategy. We can all calculate the maximum dollar risk, but because each of us makes risk-management decisions differently, the true risk is not something easy to measure.
Yet we must have some handle on risk to know whether it’s justifiable – considering the reward we want to earn. Options trading does offer substantial rewards. That’s the attractive part. It is well known that options are not risk free, and it is an individual decision on just how much risk to take. The problem is that many are unable to quantify risk.