Risk Management Is a Vital Skill

The Key to Becoming a Successful Trader

Risk Management
Managing risk. google images

Whether you are a short-term trader or a longer-term investor, your chances of being successful over your investing career, are higher when you understand risk management. 

Investing vs. Trading

Traders have a different perspective than long-term investors because they seldom, if ever, hold a position for more than a few months. In fact, many trade so actively that they hold positions for a small portion of one trading day.

It is common for some to buy an asset and sell it within a few minutes or even a few seconds.

The primary risk-management method for short-term traders is never placing too much money at risk for a single trade. Option traders have additional risk-management tools and strategies available.

Passive vs. Active Investing

Because the stock market tends to move higher over the years — despite some very significant and scary declines — it may seem that the best strategy is to invest money in the stock market, and essentially to let that money sit there and work for you. And the truth is that there is a mountain of data that proves that individual investors who trade less often fare far better than investors who make frequent changes to their portfolios.

That said, I do not recommend that investors adopt buy and hold as gospel. It is important for your future financial well-being to periodically examine your holdings.

After all, it is not reasonable to expect that the stock you bought a number of years ago is still a worthwhile holding. The situation has changed over the years, and purging stocks that no longer meet your investment criteria is a sound idea. More of this concept below.

Actively Managing Risk

Regardless of how often you make a change to your portfolio; regardless of whether you trade actively or passively, do not become complacent when you are earning good profits.

It is important to be aware of what can go wrong (i.e., just how much risk you are taking with your portfolio), and to take corrective action to minimize risk. Obviously, the investing/trading game is never risk-free. Thus, the goal of successful traders/investors is to keep risk under control. To help accomplish that, a list of useful strategies is listed below. The objective is to minimize losses and be certain that they never overwhelm the profits earning from your winning trades.

Specific Strategies

1. Do not go broke. This seems to be pretty basic, but newer traders with small accounts run the risk of blowing up an account when they adopt strategies where risk is not fully understood. Do not lose so much of your money that it will make it difficult, if not impossible, to return the account to an acceptable level. Investors cannot expect to earn money in a $1,000 account. It is just too difficult. It is better to invest in an index fund. Traders who use a small account will be forced to use too much of their capital on each trade (i.e, it's not feasible to invest $50 per trade because commissions would be prohibitive).

It is important to stay in the game for the long term. Thus, any loss must be affordable.

Equity traders can limit risk by simply managing the number of dollars invested per trade. Option traders must be more careful — especially for people who prefer to sell put options or option spreads. Note that it is possible to sell naked (unhedged) call options, but most brokers do not allow their customers to adopt that strategy because — in theory — the possible loss is infinite.

2​. Trade appropriate Position size. No matter how attractive an individual investment seems, investing too many of your portfolio dollars in a single trade is a poor strategy. Sure, if your normal investment is $5,000, feel free to invest $5,500 or maybe even $6,000 instead.

But do not fall into the trap of investing $10,000 or $15,000 just because the deal looks too good to be true. This warning is especially valid for option traders who believe that out-of-the-money options can be sold with almost no risk. 

Many an option trader has gone out of business by selling too many of those options. Remember that other traders are buying those options, and there is no reason to believe that those buyers have no idea what they are doing. Maybe they know something that you don't. Maybe the company has news pending (an earnings report, for example) and that alone makes it much more likely that the stock price will gap higher or lower once the news is announced. News pending makes it reasonable for people to pay higher prices (due to an increase in implied volatility) for options, and you do not want to get caught in a situation in which you did not know that an earnings report was imminent. Selling naked options comes with risk and is not for unsophisticated option traders who are not experienced in managing risk.

This principle holds for traders and investors. If you can trade appropriate position size, you will have taken the first step towards skilled risk management. 

3. Write a trade plan. For investors, the plan should not be too complicated. the basic idea is to put into writing your specific rationale for making this trade. Include investment objectives, such as the rate at which you anticipate that your investment will grow, and how long you will give this investment before you decide that you made a mistake. It's okay to give your plan a year or two to work, but do not stay married to a company or business that has under-performed your expectations.

Do not be afraid to take a loss in a given investment because you can probably find a better place for your investment dollars. Getting back to even should not be defined as recovering lost money from a specific stock. Instead, it should be thought of as recovering the money that was lost by dumping the loser and reinvesting in a company with better prospects for the future. ​

4. Be willing to accept losses. You are not infallible and some of your trade decisions will result in a monetary loss. You must accept that fact. As risk manager for your investment or trading account, it is your job to maintain a portfolio of investments that meet your investment criteria.

Investors: Through the years, you will find that you own stock that is not only performing poorly, but whose future outlook is not promising. Do you remember when you bought that stock? Do you remember why you made the purchase? By the way, this is one reason for writing a trade plan. That plan should include answers to these questions.

When conditions change and when the company is no longer positioned to grow its business according to your expectations, that is the time to sell the shares and move the cash into a different stock. It does not matter whether the shares are sold at a profit or loss. The only thing that should matter is that this stock no longer deserves a spot in your portfolio. Replace it with one that does. Remember that you want your money invested in companies whose stock prices have the best chance to increase over time.

Note: Sometimes stock prices decline for reasons that don't have anything to do with the specific stock. For example, during bear markets, most stock prices move lower. If your company is doing well — based on their annual earnings and revenue growth — then there is no reason to sell.

Traders: When you entered into the trade, you had near-term expectations. If the position price goes the wrong way and you are losing money, it is often the best practice to admit that your expectations will not come true. Exit the trade and take the loss. The shorter your anticipated holding period, the more important it is to bail out of a bad trade. For example, 60-second traders recognize that they need a favorable price change to occur quickly. If it does not, then the rationale for entering the trade proved to be incorrect.

Note: Investors can afford to wait when the stock price changes but the company's business outlook remains strong. Short-term traders cannot adopt that philosophy. If the trade does not work, it is probably true that your timing was wrong and it pays to exit the trade. That's how losses are minimized.

1​. Asset Allocation for investors. The basic idea behind the strategy of allocating your investment dollars among different assets is to minimize risk. Most of the time, when one asset class declines in value, another will not. For example, stocks and gold tend to move in the opposite direction.

The idea is to never have all your money invested in a single asset type. That way your entire portfolio is unlikely to be in a bear market at one time.

In practical terms, most investors do not have sufficient capital to spread their money among several different asset classes. These people tend to place all their investment money into the stock market. If you are one of those investors, allocate assets by owning stocks in different industries and owning some stocks that pay high dividends.

Traders don't have to be concerned with asset allocation as long as they do not have too much of their capital at work at any one time. Because each position must be watched closely ((especially for day traders), one or two positions should be the limit. Thus, most of your assets remain in cash, and that is enough to limit losses.

One final point on asset allocation: At times you will own one or two stocks that outperform all the others. When that happens, those stocks will represent a percentage of your portfolio that is too large. Sell some shares, reduce the total value of those stocks to the same level as the other stocks, and reinvest the cash elsewhere. Similarly, when a single stock under-performs, if it still is worth holding in your portfolio, buy additional shares. This plan keeps each investment at an appropriate level.

2​. Own in-the-money call options instead of stock. When you are concerned about the possibility of a market sell-off, don't try to time the market by selling your assets. Instead, cut downside risk by selling stock and replacing each 100 shares with one in-the-money call option. If the stock price tumbles, your loss will be far less when you own call options instead of stock. On the other hand, if the stock price rallies, you will participate on the upside almost on a point for point basis.

Good risk management requires two personality traits. The first is the ability to accept a loss; the second is discipline.

There exists a class of traders who are never willing to admit that they made a money-losing decision. They hold trades until they cannot stand the pain. Stubbornness is not a trait that is good for traders. There is little hope that people in this group can be successful traders.

If you recognize that it is time to close a position and lock in a loss, that is not sufficient. You must have the ability to act with discipline and enter the order with your broker. Procrastinating, with the hope that the position will turn around, is not a winning strategy.