I was told at OASIS that the company provides a consistent message about managing risk, but at times it's still difficult to understand exactly how one is to accomplish this. Unfortunately, since risk is a bit of a fuzzy thing by nature the notion of managing it is also fuzzy. This month's article series attempts to identify some practical approaches for traders to quantify risk so they can manage it. We'll see how it goes.

Risk Defined

Risk is generally associated with financial losses first, then problems associated with assets not keeping pace with inflation. Different life events that can create financial risk are addressed via insurance. Insuring a financial risk is probably one of the last things you are thinking about when managing a trade, but not protecting yourself could certainly add to trade stress.

Know Your Risk

Managing your risk means you must know your risk; meaning you must be able to quantify potential returns and losses for both your longer-term portfolio positions and shorter-term positions. On the portfolio side you should estimate:

• Expected returns for a portfolio given historical performance
• How the different asset types in the portfolio behave relative to each other
• Potential fat-tail losses or historical outliers that could impact portfolio returns
• Inflation trends that could impact future buying power

On the portfolio and trading side you must also know:

• The total potential risk for each individual security held
• How security combinations effects potential returns and losses
• How high and low volatility environments effect your positions
• Market/exchange rules & margin requirements

Hedging

Option traders can hedge their portfolio to reduce losses when the markets move in a direction counter to your holding(s). The cost of the hedge may dampen returns if the markets continue in the same direction or move sideways. Managing risk means quantifying the loss risk associated with an un-hedged position as well as the dampened returns for the hedged position. This assessment may favor a position exit rather than a position hedge.

Position Risk & Exits

Position sizing and trade exits are probably the two areas most closely associated with managing risk. The position size may be a dollar amount (poses problems) or a fixed/variable percent of the trading portfolio. It may also be backed into using the trader's max risk and taking the difference between the current price of the security and a trader identified stop level.

In order to effectively manage exits, a trader must understand how different order types are used and the potential shortfalls associated with each. Total trading costs must be estimated for different approaches and incorporated into system assessments to determine if it is truly viable.

More detail on all of these topics will be covered in the weeks ahead.

Vive le Tour.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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