Be honest with yourself – as a trader, are you taking on enough risk?
A bizarre question on the face of it. Surely prudence dictates that a trader goes all-out to minimise risk, to protect against the downside while leaving plenty of room for the upside to flourish?
After all, trading can cost you all your original stake money and sometimes more. Is it any wonder that how-to guides for traders are packed full of solemn advice about stop-loss positions and hedging strategies?
Only a dummy would actively seek out more risk. Wouldn’t they?
Risk inseparable from returns
Well, it is quite true that assuming risk simply for the sake of risk would be a pointless exercise that would almost certainly result in loss. It would be easier and more satisfying to give the money away to a worthwhile cause.
But risk is inseparable from return, which is why financial professionals seek out, on their own and their clients’ behalf, asset classes that offer “an attractive risk/reward profile”. In other words, securities and situations in which the price, for whatever reason, exaggerates to some extent the risk, thus underestimates the potential reward.
The security is under-priced when these factors are taken into account.
Seeking out such good-value propositions is an essential trading skill, which we will turn to in a moment. First, however, the principles behind embracing risk, rather than running away from it.
Here is an example of a perfectly hedged position. You place equal and opposite bets on both the players in the Wimbledon men’s tennis final. There is absolutely no way you can lose. Nor, sad to say, is there any way you can win.
Such strategies arise from a fundamental misunderstanding of the relationship between risk and reward. Risk is not some unfortunate by-product of reward or an obstacle to profitable trading that needs to be avoided. The reward is a reward for having assumed the risk in the first place.
Check all assumptions
Bank deposits and government securities are sometimes referred to as “risk-free assets”, being safe and usually guaranteed. They certainly carry a negligible level of risk but this is reflected in the very low level of returns they offer. Nobody is going to get rich on a savings account.
But nor are they likely to trade or invest in riskier assets if the returns are little improvement on those available on risk-free assets. The riskier the proposition, as a rule, the greater the potential reward. It is precisely because the chance of losing your money is increased, that the reward has to be similarly increased.
In a mathematically perfect world, all these different risks and rewards would cancel each other out. The proportion of risky assets or strategies that failed, taking all the trader’s money with them, would be balanced by those that succeeded, returning an equal amount of money to the traders who had backed them.
Netted out, the trading community as a whole would be no better or worse off than if its members had stuck to risk-free assets.
A first step is always to check and then double check the assumptions behind your risk/reward strategy. You are convinced, for example, that the market is over-pricing the risk of trading sterling and, as a consequence, is under-pricing the potential rewards.
Why do you believe that? Is your view based on previous trading patterns, or on your interpretation of recent news events, or on the economic fundamentals of the UK economy? Whatever the case, subject your view to searching scrutiny.
It has been suggested that the stop-less level can be used to calculate a numerical risk/reward ratio by comparing the stop-loss price with the expected potential reward. If the former is $100 and the latter is $200 then the risk/reward ratio is said to be a respectable 1:2. By contrast, if these figures were reversed, the risk/reward ratio would be a very unappealing 2:1.
The trouble with such calculations is that they can give a misleading impression of objectivity. While the stop-loss – the risk level, in effect – is fixed by the trader, the potential rewards may or may not materialise. There are no guarantees.
Even when calculating the risk/reward ratio, there is no escape from risk. Hence the need to check and double-check every assumption that has been made.
American credit-management guru Abe WalkingBear Sanchez would startle business audiences by suggesting their firms had too little bad debt on their books. Too little, not too much. A low level of bad debt, he claimed, showed they were not advancing enough credit, thus were missing profitable sales opportunities.
Much the same can be said of trading risk and, indeed, of trading losses. Minimising risk can mean minimising also the chance for profitable trades. Risk should be embraced and then managed, in such a way as to mitigate as far as possible the losses that are and always will be an inevitable consequence of financial trading.
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