To wrap-up the series on risk, some security-specific risk is considered. These include volatility and leverage. Brief coverage on each is provided here and the reader is encouraged to perform an article topic search on subject where more detail is needed. Simply put, you must know your risk.

Volatility

In addition to different types of securities behaving differently, securities within the same asset class will move to a different extent and/or direction. While a bigger move is more advantageous when you are on the right side of the position, it also means it will cause deeper pain when you are on the wrong side of it.

Figure 1 provides returns for eight different stocks over the same three year period used for exchange-traded fund [ETF] returns discussed in the August 6th Analytical Toolbox. 100-day statistical volatility [SV] levels for each were obtained from Platinum to provide a sense of how these values impacted the end of period returns.

Figure 1: Three Year Returns for Eight Stocks with Varying 100-day SVs
click here for larger view

Clearly SV alone was not the only determinant in end of period results; otherwise, those for RIMM and GS would be much closer. In addition to the path of returns (gains followed by losses) you have to consider SV for the whole period represented by the returns.

As an additional consideration, option traders need to have a handle on relative volatility levels for both SV and implied volatility [IV] so they can create strategies that are reasonable given previous movement in the underlying.

Leverage

Leverage can be added to investments via margin (futures) or security selection (ETFs that employ leverage). Adding leverage to a position creates a situation similar to selecting a stock with greater volatility - both gains and losses are amplified. Figure 2 provides return data for the same eight stocks over the same three years, using leverage by assuming a 50% margin position is established for each. The ETF returns from the review completed earlier in the month is also provided.


Figure 2: Three Year Returns for Eight Stocks Using Leverage (Assumes 50% Margin)

Leverage will not simply double the losses or gains, the end result is determined by the compounding effect of consecutive losses or gains.

Timing

Leverage by itself is not necessarily a problem. Entering a leveraged position when the market is moving in the right direction can be profitable. Figure 3 provides return data for the three ETFs over a bearish period.

Figure 3: ETF Return Data Over a Four Month Bear Period

However, unless you have a fool-proof method for proper market timing, you need to consider the additional risk to your position when you are using leverage.

Risk Summary

The impact of Volatility, Leverage and Timing from a "what if I'm wrong?" standpoint must always be considered prior to establishing a new position. Identifying maximum risk for a position by identifying an exit level and method of executing that level is one key to longevity in the trading business. Approaching all trades in this manner allows you the time needed to determine the appropriate money management techniques for the different strategies that suit your style. This in turn leads to long-term success as you compound a greater amount (number or size) of positive returns

There is no one method that is right for any of these different trade management issues. Generally the ones you'll follow with discipline are the ones that better suit your style, which is the main thing that will take some find to determine. Cornerstone is the most comprehensive course to help you map out all of these things. The process of creating a trading plan is completed by addressing each of these items and referencing dozens of additional resources so the plan is extremely specific.

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