Trading with Additional Risk

Substantial Rewards are Never Guaranteed

Market Risk
••• Risk vs. Reward.

Surfing the Internet, I came across the following quote by Eric Falkenstein. It concerns risk taking, and although the statement may seem to be trivial, it is far from it. It is an important concept. 

Don’t expect to make more money for taking risk, just know you have to take additional risk to make more money.

If you don’t understand the difference, you should not be taking risk.

One of the basic concepts regarding investing is that there are no free lunches and that you, the investor, must take some risk in order to earn a return on your investment dollars.

If you are a very skilled trader, you may be able to get away with taking very little risk. However, for the vast majority of investors/traders, we must take on additional risk when we seek to earn a higher profit.

I hope that makes sense. If you were able to earn a high reward on your investments with very low risk,  then almost every investor on the planet would go after those rewards.

Usually, no further discussion is required because we all understand when many people go after the same investment product, then there are often those who are willing to accept a slightly lower reward. That, in turn, drives down the overall reward available to investors. To understand why this is true, just imagine a $100 bond that returned $10 every year. You love that 10% annual return. But another investor may we willing to accept less and may bid $105 for that bond. When that happens, you can no longer buy the bond for $100.

The price is now higher and the reward is now less. The process continues (i.e., the cost of the bond increases) until equilibrium is reached and no one is willing to pay a higher price. By the time that happens, the bond could easily be selling for $120 and the annual return would be 8.33%.

The major point that Eric makes is that extra risk does not guarantee any extra reward. In fact, there may be no reward. Imagine a careless, inexperienced trader adding risk to his/her portfolio with the expectation that it will lead to greater gains.

Using the above bond example, the fact that the business had to pay as much as 10% to sell the bonds initially suggests that the company may never be able to repay the debt. Financially sound companies do not have to pay so far about current market rates when selling bonds. The fact that this company has to pay so much in order to attract lenders says a lot about the high risk involved when lending money to them. It's great to earn $10/year per $100 investment, but if the company defaults and you never get back any of the $100 invested, that is an example of no reward.

In the trader's world, it is possible for the trader to be in over his/her head by accepting more risk than the trader can handle. And the sad part is that it may not be immediately obvious to the trader just how much risk is involved with a given trade/investment.

A trader may adopt a new strategy or trading style successfully (i.e., it makes extra money), without recognizing that the trade involved extra risk. Until the 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 possibilities -- the trader may enjoy those extra gains.

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 larger position 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 trades before being certain that you are prepared to handle that risk. It’s a very good idea to earn a bit less money when you can do it with substantially less risk.  

Risk Premium: Definition: The minimum anticipated return required to entice the investor to own the position.

We all recognize that options trading involves some risk (the super-risk adverse, computer-assisted, trader can neutralize positions efficiently). We can all calculate the maximum dollar risk for a given option position, but because we each make risk-management decisions differently, the true risk is difficult to measure because the whole concept of risk includes far more than the total sum that may be lost. It also involves probabilities and the likelihood of various outcomes. Not to mention the trader's discipline.

Yet we must have some handle on risk to know whether it’s justifiable – considering the reward we want to earn. Options trading offers the opportunity to earn 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 most brand new traders are blind to risk.