Risk Management

 

If you can not manage risk, you can not manage profit as well, and you will not be a profitable trader in your entire life. Managing risk is a very crucial part in trading as well as in investing. When you invest or trade, you cannot avoid risk, you need to take risk and manage it well.

Sports & Trading

Simon Ramo identified the crucial difference between a Winner's Game and a Loser's Game in his excellent book on playing strategy, Extraordinary Tennis for the Ordinary Tennis Player. Over a period of many years, he observed that tennis was not one game but two. One game of tennis is played by professionals and a very few gifted amateurs; the other is played by all the rest of us. Although players in both games use the same equipment, dress, rules and scoring, and conform to the same etiquette and customs, the basic natures of their two games are almost entirely different. After extensive scientific and statistical analysis,

Dr. Ramo summed it up this way:

Professionals win points; amateurs lose points.

Professional tennis players stroke the ball with strong, well aimed shots, through long and often exciting rallies, until one player is able to drive the ball just beyond the reach of his opponent. Errors are seldom made by these splendid players.

In his thoughtful treatise on military science, Strategy and Compromise, Admiral Morrison makes the following point: "In warfare, mistakes are inevitable. Military decisions are based on estimates of the enemy's strengths and intentions that are usually faulty, and on intelligence that is never complete and often misleading." (This sounds a great deal like the investment business.) "Other things being equal, concludes Morrison,

"the side that makes the fewest strategic errors wins the war”

The victor in this game of tennis gets a higher score than the Opponent, but he gets that higher score because his opponent is losing even more points Golf is another Loser;s Game. Tommy Armour, in his great book How to Play Your Best Golf All the Time, says:

"The way to win is by making fewer bad shots.

As I am reading the wonderful book “Winning The Loser’s Game” by Chares D Ellis, it’s a great read, Charles wrote many books, but this book I Enjoyed lot, simple, deep insights, and practical.

The question arises, how?

How you can beat the market? But beating the market is loser’s game, lets reframe the question,

How you can get extraordinary returns? Or How you can manage risk?

The answer is Make less strategic mistake by managing risk well.

When beginners start learning martial arts or boxing, they almost always want to start by learning how to punch or strike their opponent. That is the most thrilling element of practising martial arts for them, and they are eager to learn to attack. The trainer or coach, on the other hand, will normally begin by teaching them how to defend themselves or block an attack. If you can't defend yourself against being hit, you won't be able to attack your opponent. Most beginners overlook the significance of defensive skills. The motto in sports is that defence wins championships.

After all, even if you earn points, you cannot win if you allow your opponent to score more.

Defence is equally important in option trading. Beginners and professional traders alike want to concentrate on trading methods and profit. They frequently neglect the significance of defence. Of course, we are not at risk of being punched or attacked when trading options, but the money we invest is constantly under attack. We are up against thousands of other traders and investors who want to "take" our money.

Investors and traders must learn to safeguard their capital against losses in the same way as boxers must protect their bodies and minds. Allowing too many losses, or "attacks," on your trade capital will leave you bankrupt and out of the game. As a result, option investors must initially focus on defence before going on offence and executing trades or constructing positions.

Risk and trade management are two defensive skills that any investor should learn before focusing on trading methods. Learning how to monitor and manage the risk of each trade, as well as your overall portfolio, is critical to protecting your cash. Many investors have experienced making money on a series of deals just to have one or two disastrous trades wipe out all of their hard-earned profits. Imagine working hard during the first six rounds of a boxing battle to weaken and harm your opponent, only to come out in round seven with your hands at your sides and be knocked out. Ignoring risk and trade management is similar to entering a boxing ring with your hands locked to your sides, leaving your entire body and face exposed.

We believe that the right use of trading and risk management is what separates a good investor from a bad one. This is not a claim that stock selection, market timing, and analytical skills do not play a role in traders' success. However, trade and risk management allow such competent investors to keep the rewards of their work rather than giving back all of their gains.

As a result, our first step before learning trading methods is to examine risk management fundamentals. You will not learn this ability by simply reading this post once. You must study the principles and put them into practise while you trade. It takes some time for it to become embedded in your trading style. We are all prone to the emotional tension, worry, and thrill that comes with trading and gaining or losing money. The fundamentals of risk and trade management help remove much of the emotion from trading and go a long way towards helping you avoid making costly mistakes as much as possible.

THE PHILOSOPHY OF RISK

The concept of risk is the most misunderstood in investment and finance. However, risk is at the heart of investment. Remember the old saying, "It takes money to make money." What this truly means is that in order to make money, you must put money at risk. To obtain a reward, you must put some of your cash at risk. The motivation of the prize is what motivates you to accept the risk. Because you must risk money in order to earn your reward, finance is all about pricing and measuring that risk in order to assess whether the reward is worth the risk.

For example, govt bond offering you 6% bond yield, with safety where as private organisation offering you 6% with no guarantee or less guarantee, where you invest, off course in govt bonds. But private organisation offering you 8% instead 6%, you will be considering investing in it. Its all about Risk to Reward. And it’s completely personal thing to do.

This example summarises the underlying rationale for all investment decisions. We want to know the danger of the investment as well as the return for taking such a risk. If we have two investment options, the best method to choose the best one for our money is to analyse the risk and reward of each investment to see which one provides the most reward for the amount of risk we must accept. As a result, before making any trade, you should carefully identify and quantify the investment's risk and reward. In terms of options, the calculation of risk and return is fairly simple and is covered in our first and most fundamental risk management principle:

Measure Maximum Risk

Before committing any money to an investment, you must be able to define and quantify the maximum risk (loss) and maximum profit, as well as the breakeven points.

This theory necessitates calculating the greatest risk, maximum gain, and breakeven points for any trade you are considering. Even if you don't make these decisions before starting a trade, you should be able to look at any existing trade and instantly determine the maximum risk, maximum gain, and breakeven thresholds. These three things should become second nature to you. We cannot overstate how critical it is for every investor to understand and be able to figure out these three factors before going into any position.

You are a Risk Manager

You are first and foremost a risk manager, then an investor or trader.

Most traders begin by considering the maximum reward since they are solely concerned with how much money they can make.

They forget that in order to make that money, they must first take a risk.

Greed causes you to prioritise your reward over your risk assessment, which leads to costly blunders. Many investors, for example, become fascinated with the idea of selling options to take in premium since they immediately receive a credit. They are preoccupied with how much money they will make and pay little attention to the tremendous risk that comes with selling naked options. Unfortunately, they only discover about the risk after they have experienced significant losses and must give up the game entirely.

Always consider how much money you could lose first. Concentrating on how much money you could lose puts you in the mindset of a risk manager. Once you understand and accept the amount of money you could lose, you can make a more informed decision about whether you want to proceed with the analysis and possibly the transaction. You'll start making decisions based on how you can quantify, regulate, and reduce your risk.

TRUTH ABOUT REWARD

Before we go into risk and trade management, let's dispel some illusions about the rewards of option trading. It is critical for traders to understand and appreciate the risk associated in trading options by removing some of the common myths about the potential benefits. The following idea appears to be self-evident, but we discover that far too many traders, both beginner and experienced, fall victim to the worst misunderstanding of all:

Option trading is not a get-rich-quick scam.

The potential profits of option trading are substantial, but it should not be viewed as a get-rich-quick scheme. Traders hoping for quick money wind up trading on emotion and greed rather than careful analysis and risk management. The desire for money drives investors to seek out the next deal with zeal. They are more prone to take needless risks in order to maximise their return, and those additional risks frequently result in huge losses. It's even worse if they get some early positive findings. If an investor has a string of winning trades, they create a false sense of invincibility and ego and proceed to raise the stakes in their already risky trades, eventually losing everything.

Play a Long-Term Game

Play a long-term game in trading, focus on long term returns, just by focusing on 2% per month return you can double your money in 3 years approximately, and it’s a huge return. While focusing on making 2% per month you are ultimately taking less risk comparing to making 5% per month return.

The truth about rewards is that they take time and effort to achieve. It is unreasonable to believe that anyone can begin trading options and turn Rs 5,000 into Rs 100,000 in a year. As a result, you should have a realistic plan for the kind of incentives you can receive and when you can earn them. Making money in options demands a great deal of dedication and discipline. Investing in options is analogous to launching a business. Most investors lose money in the beginning, and it takes a lot of effort, research, expertise, and sometimes some luck to be successful and start delivering results. As a result, the early phases may be rather difficult, and you may even believe that the market is trying to get you.

So, by summarising this post, understand risk is foremost important thing to do, and managing the risk is ultimate thing to do as a trader.

While reading a book “Against The God Against the Gods: The Remarkable Story of Risk” this book is all about dealing and managing risk. Peter L. Bernstein says,

“Survival is the only road to riches” 

 Happy Investing & Trading

The ValuePlusOptions Team