MONEY MANAGEMENT

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Risky Business

Risk/Reward In Trading

by Don Bright

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Every investor and trader has been taught to be fearful of risk in the marketplace. That makes sense, right? You have to be cautious with your money, right? You have to limit losses, right? Well, maybe not.

As in most other things, risk in the marketplace comes with a counterpart: reward. These rewards can be financial, physical, mental, or even emotional. We all risk so many things every day, from the moment we get out of bed in the morning, head to work in traffic, engage our peers in conversation, and otherwise negotiate our way through day-to-day life. Even matters of the heart involve risk and reward; how many people are too afraid of rejection to pursue a satisfying relationship? For now, though, let's just take a look at risk and reward in the investment and trading world.

APPLYING STOP-LOSSES

So many of my learned peers support the theory of tight stop-loss methods when investing or trading. This seems to make perfect sense on the surface, but look a bit deeper. If you buy 100 shares of stock at $50, and hope to get an annual return on investment (ROI) of 12%, the stock would have to rise by $6 annually (assuming there were no dividends paid). To protect yourself from ruin, you can enter an initial stop-loss sell order to trigger at a predetermined price. How much should you limit your loss? How does this individual stock movement affect your overall portfolio?

Rather than go down the mundane road of percentage calculations based on overall bankroll (portfolio), standard deviation of historical volatility per stock/sector, and the whole number-crunching approach to what might happen if the stock were to move x percent over a t time frame, let's take a more universal and, yes, much simpler approach

....Continued below for limited time only.

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Excerpted from an article originally published in the October 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.

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MONEY MANAGEMENT

Risky Business 

Risk/Reward In Trading

Every investor and trader has been taught to be fearful of risk in the marketplace. That makes sense, right? You have to be cautious with your money, right? You have to limit losses, right? Well, maybe not.

by Don Bright

 

As in most other things, risk in the marketplace comes with a counterpart: reward. These rewards can be financial, physical, mental, or even emotional. We all risk so many things every day, from the moment we get out of bed in the morning, head to work in traffic, engage our peers in conversation, and otherwise negotiate our way through day-to-day life. Even matters of the heart involve risk and reward; how many people are too afraid of rejection to pursue a satisfying relationship? For now, though, let’s just take a look at risk and reward in the investment and trading world.

 

Applying stop-losses

So many of my learned peers support the theory of tight stop-loss methods when investing or trading. This seems to make perfect sense on the surface, but look a bit deeper. If you buy 100 shares of stock at $50, and hope to get an annual return on investment (Roi) of 12%, the stock would have to rise by $6 annually (assuming there were no dividends paid). To protect yourself from ruin, you can enter an initial stop-loss sell order to trigger at a predetermined price. How much should you limit your loss? How does this individual stock movement affect your overall portfolio?

    Rather than go down the mundane road of percentage calculations based on overall bankroll (portfolio), standard deviation of historical volatility per stock/sector, and the whole number-crunching approach to what might happen if the stock were to move x percent over a t time frame, let’s take a more universal and, yes, much simpler approach.

 

Let’s play the trading game

Let me start with a couple of definitions to make sure we’re on the same page. When I use the words trader and investor, you should visualize two entirely different entities. The investor is looking for a decent Roi on a static financial investment. The trader is constantly turning over shares in the hopes of extracting profits from the net transactions on an intraday or daily basis. There is, of course, a gray area that often blurs the two.

    Since we’re talking about controlling risk, let’s skip discussing the entry-point setup for your trade. I assume you have taken into consideration all the basics when entering the trade (momentum, relative strength to sector/market, support/resistance, and so on) and now own 1,000 shares of Rsk at $50. Investors choose to think that they have now spent $50,000 and are now looking for a fair Roi. The trader chooses to think he or she has “opened” a position at $50, with the potential to make or lose $1,000 for every point the stock moves.

    This fundamental difference in thinking can have a major impact on how traders respond to stock movements, how they interpret the market, and how well they play the game. Concern over $50,000 is obviously much more intense than pondering $1,000 or a fraction thereof. Let’s explore this: If your plan is to make $100,000 per year ($500 per day), then all you need to do is make 50 cents, on average, for this 1,000-share trade. Now, how much are you willing to risk in order to make $500?

    Let’s try some basic math first. If you plan on having a reasonable win/loss rate of 70% profitable versus 30% unprofitable trades, then you only need to make about half as much per trade.  [per trade? yes, 7 x $500 = $3500 minus 3 x $1000 ($3,000) = $500 profit] as you lose to be profitable on a per-day basis. [Don: please make sure this sentence is clear.] (Naturally we prefer to limit our losses and expand our profits whenever possible.) Note this is a major assumption that only applies to seasoned, well-trained traders. (Don’t forget to add in your commissions and other costs on both sides.) So you may be willing to risk up to $1,000 to make $500. You may want to adjust this accordingly to your own win/loss percentage.

    If your win/loss percentage is only 50/50, then you need to rethink the idea of trading for a living altogether. You also need to examine your entry/exit criteria carefully to determine what errors in timing you may be making.

 

Risk awareness

Think of risk not just in terms of dollars, but also as the amount of time expended in your trading. In a basketball game, there are only so many minutes in which to score; in a similar way, each trading day has time limits. If you are spending time (that is, risking valuable time) involved in a bad trade, searching for the perfect trade (which, except for pure arbitrage, doesn’t exist), or spinning your wheels getting whipsawed for fear of taking a larger loss, then your risk is much greater than you may realize. An accountant, for example, is risking precious time whenever he or she is doing nothing; in essence, he is spending money that could otherwise be billed to his clients. The trader who spaces out looking for that nonexistent perfect setup is doing the same thing.

    Go into trading with the idea that you need to be good, but not perfect, because no trader is. With this type of pragmatic attitude toward each entry/exit point, you should be able to get past the fear of making a mistake (which is a major risk for any serious trader). Much like swinging a bat at a ball, the more you practice, the more pitches you face, the better you become. If you think of the market as a pitcher who is always throwing something new, then you will learn to respond instinctively rather than try to predict the unpredictable next market move.

 

Keeping your poker face

Now that we have covered some of the more esoteric aspects of risk, let’s get back to some basic pragmatism. I rarely, if ever, use mechanical stop-loss orders. The reason is simple: I don’t want to give away my “poker hand” to the specialist or a broker. The game of trading is played much like poker, and you need to keep your hand to yourself. And, since bluffing is allowed, you cannot always rely on what is being reflected on the screen (bid/offer size and price may or may not be accurate, or may actually be hidden by software functions such as RediReserve and so on). Even the Nyse open book is somewhat delayed, and usually does not reflect short sales.

    Here’s an example of how stop-loss orders can work against you. Suppose you just bought 1,000 shares at $50. The bid is now 49.90, and the offer is 50.10. There are, of course, many orders to buy the stock in the “book” between 49.00 and 50.00. If a broker came to the specialist and had a very large order to sell the stock at a lower limit, or market order, he may actually negotiate a price limit of, say, $49.00 even to trade the larger block order. Now, if you had a stop order in to sell at 49.50 (a reasonable amount of loss risk), you would sell the stock at 49.00 on this negotiated trade, since your stop order is merely a trigger price, not the trade price. This would result in a $1,000 loss, of course.

    Remember, you should learn a few stocks well, learn how they trade, and trade them daily to become proficient at this game. If you used a mental stop, or alert, then you would have a chance to evaluate the situation before having your trade automatically entered. We teach our people to keep an eye on all the primary indicators at all times (S&P premium/discount, sector, Trin†, and so on) and if they did not see a major shift in the overall market, they would make the logical assumption that this particular trade was simply an aberration, and not indicative of a major price shift in the stock.

    We prefer that traders use the computers in their heads — logical thought processes — rather than lock themselves into a predetermined cause-and-effect scenario. If/then statements are not always black and white in the markets, and we prefer to take that extra half a second to evaluate the situation before making a financial decision.

    This is just one simple example of why you may want to rethink the idea of mechanical stops. If your response is, “I can’t watch the market all day,” then you must understand that you will be subjecting yourself to more risk by not being there than if you would if you were to stay out of the market that day. Remember, part of risk is your valuable time!

    Always keep enough money available to play the winning game the next day, and rely on your own risk tolerance for making decisions about when to exit a trade and why. There are too many variables involved in professional stock trading to rely on a mechanical decision-making process for risk control. Here is a simple thought process about when you should exit a losing trade: If you think you can get back into the trade at a better price, then go ahead and close out now. If you buy at 50.00, sell at 49.80, and get back in at 49.50. Then at least you saved yourself the gap in between.

    As a trading firm, we have to watch overall risk for our hundreds of traders, but we rely heavily on the ability of the professional trader to keep his or her risk in check. We hope that individuals value their hard-earned money, and are not willing to take unnecessary risk. This is a profession that weeds out gamblers quickly, but rewards the careful player with a good understanding of true risk and reward.

 

To sum up

The trader should keep these points in mind:

 

1    Use mental stops or alerts; don’t reveal your hand to other poker players.

2    Respond to the stock movement; don’t react to a simple price change.

3    Close out a bad trade by remembering you can always get back in at a better price (overcome the covering-at-the-bottom syndrome).

4    Plan to win more often than not, but don’t expect to win on every trade.

 

Don Bright is with Bright Trading (www.stocktrading.com), a professional equity corporation with offices around the US. He is the author of S&C’s monthly Q&A column “Since You Asked” (page XX).