WHAT IS RISK?

DEFINING RISK FOR TRADERS

Options were designed as risk-reducing tools, yet most people begin trading options by adopting high-risk strategies.

Why does that happen?

·         Overconfidence. Traders tend to concentrate on profits and ignore the chance of losing money.

·         Some strategies "feel" safe. When investing a small sum, traders ignore the fact that they will lose money at least 90% of the time.

·         It is easy to forget that a string of small losses adds up.

·         Traders do not look at risk in enough detail.

DEFINING RISK

The term "risk" can be defined from different points of view:

A dictionary tells us that risk is 

·         A situation involving exposure to danger. For traders, that danger is a monetary loss.

·         The possibility that something bad or unpleasant (such as an injury or a loss) will happen.

·         The potential of losing something of value, compared with the potential to gain something of value. 

As a trader, I recommend using the last definition because it forces you to consider what you have to gain and compare it with what you have to lose.

In other words, do not make a trade when risk is too high for the potential gain.A financial dictionary could define risk as

1.       The odds that the return on an investment will be different than expected. This is especially important for the conservative investor who depends on a steady income stream. 

2.       The possibility of losing all, or a portion, of the original investment. 

3.       The total amount that may be lost.

Notice the subtle difference between #2 and 3: One defines risk by using the probability that something will go wrong, and ignores how much money is at risk; while the other ignores those probabilities and concentrates only on the total sum at risk.

For our purposes as option traders, I urge you to be aware of factors #2 and 3 at all times. That means examine risk when initiating the trade, while holding the position, and when planning the exit. Think about: What you have to gain vs. what there is to lose.

 MY BASIC TENETS:

·         Every successful trader pays attention to Risk management.

·         Correct position size is the number one step when managing risk 

TAKEAWAY: Risk management is not a difficult concept. Pay attention to risk as you learn about trading options. It is a mistake to delay paying attention to risk management until after you are already trading.