DEFINING RISK
FOR TRADERS
Options were
designed as risk-reducing tools, yet most people begin trading options by
adopting high-risk strategies.
Why does that
happen?
·
Overconfidence. Traders tend to concentrate
on profits and ignore the chance of losing money.
·
Some strategies "feel" safe.
When investing a small sum, traders ignore the fact that they will lose
money at least 90% of the time.
·
It is easy to forget that a string of small
losses adds up.
·
Traders do not look at risk in enough detail.
DEFINING RISK
The term "risk" can be
defined from different points of view:
A dictionary tells us that risk
is
·
A situation involving exposure to danger. For
traders, that danger is a monetary loss.
·
The possibility that something bad or
unpleasant (such as an injury or a loss) will happen.
·
The potential of losing something of value,
compared with the potential to gain something of value.
As a trader, I
recommend using the last definition because it forces you to consider
what you have to gain and compare it with what you have to lose.
In other
words, do not make a trade when risk is too high for the potential
gain.A financial dictionary could
define risk as
1. The odds that the return on an investment will be different
than expected. This is especially important for the
conservative investor who depends on a steady income stream.
2. The possibility of losing all, or a portion,
of the original investment.
3. The total amount that may be lost.
Notice
the subtle difference between #2 and 3: One defines risk by using the
probability that something will go wrong, and ignores how much money is at
risk; while the other ignores those probabilities and concentrates only on
the total sum at risk.
For our
purposes as option traders, I urge you to be aware of factors #2 and 3 at
all times. That means examine risk
when initiating the trade, while holding the position, and when
planning the exit. Think about: What you have to gain vs. what there
is to lose.
MY BASIC
TENETS:
·
Every successful trader pays attention to Risk
management.
·
Correct position size is the number
one step when managing risk
TAKEAWAY: Risk management is not a difficult concept. Pay attention
to risk as you learn about trading options. It is a mistake to delay
paying attention to risk management until after you are already trading.
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