Market Risk – Are You Willing To Take It?

What is risk? Most everyone says there is risk in trading and investing,

but what is really meant by “taking a risk?” How is risk defined?

When someone takes a position in the market, they are often willing to

risk $400, $1,500, or some selected dollar amount over which a larger

loss would be too great to take. They consider themselves “risk takers,”

even among the professional ranks. After all, they are exposing their

capital to possible loss, and that means “taking a risk.” At the same time,

by limiting the risk to X amount of dollars for any given position, one is

assumed to also be protecting and preserving capital.

Or so it seems.

While most may consider it to be a smart tactic as a way to reduce risk,

in reality, it can have the unintended opposite affect. Limiting risk to a

fixed dollar amount can actually increase risk exposure, and ensure losses,

in the process.

How?

Very often, the chosen dollar amount has nothing to do with ongoing

market activity. Any predetermined fixed amount is simply superimposed

on the market as a safeguard, a supposed measure of safety. Relative to

the existing market activity, a better risk may be $2,200, instead of $1,500,

for example, and an amount that is over 5 times the amount a $400 risk

taker wants to assume.

“$2,200 is too much risk to take!”

Really?

Does the use of a money stop reduce risk, or actually increase it?

What if, over a series of ten trades, someone gets stopped out three times,

at $1,500 per stop, for a total loss of $4,500. Assume the $400 risk taker

gets stopped out seven times, for a total loss of $2,800. Those become

realized losses that have to be made up in future trades.

What about our $2,200 risk taker? He never got stopped out once, at the

$2,200 level. On three occasions, price moved $1,800, $2,050, even

$2,100 against the positions, but at no time did price move over $2,200,

the accepted risk amount for the brave soul willing to take a larger dollar

risk, without getting stopped out.

The smaller $400 “risk taker” lost $2,800. The $1,500 “risk taker” lost

$4,500. The assumed biggest risk taker did lose $1,200, the smallest dollar

loss of all three.

What happened?

The use of a larger risk kept the third trader in the position longer, and the

extra time allowed for a more informed decision to get out at a better price.

The trade that moved $1,800 against the entry price enabled the third trader

to see a recovery and ended up taking a $500 loss on the position. The same

for the other two trades. In the one that moved $2,050 against the original

entry price, the extra room eventually allowed the position to actually turn a

profit, while the third trade resulted in a loss on only $700 on a move that

went $2,100 against the position, but not $2,200, the original assumed risk.

The one willing to take a larger risk, dictated by market activity is actually

less at risk than the other two so-called risk takers.

The one willing to accept the higher risk factor, in any given trade, is actually

better off and is better protecting his capital more so than the other two “risk

takers.” This is true because the higher risk taker is going to get stopped out

less often than those who use money stops. The real risk taker makes a

determination that if a selected entry in a position is correct, it should not go

back to a specific price level. If it does, then the trade selection was wrong,

and getting stopped out is the cost of doing business.

Every risk should be defined in terms of market activity. What does that

mean? It means to define an area where price is not likely to go,based on

established trading patterns, if the trade is going to work, and that is the real risk.

For example, a bottom is identified at 720. The market rallies to 780 and then

pulls back from the high to support that is expected to hold at 745, which it does.

As price begins to rally off the identified support of 745, a long position is taken

at 752.

Where should the stop be placed?

Most would use a stop just under 745, say at 744, or a money stop that would

even allow to use 742 as a stop. The true risk taker would use a stop around

716, under the last low of 720.

Why?

If the trade is a proper trade, in harmony with the trend, the trend should hold

and price should not go back under 720. That makes 716 the safest place for

a protective stop. A predetermined money stop bears no relation to the real

risk under 720.

After a rally to 752, the market could pull back, yet again, to 733, eliminating

all stops under 745 along the way, and then resume the trend that eventually

takes price to over 820. The risk of using a stop under the 720 low was a

greater dollar amount, but theprobability of getting stopped out at that loss

was very small, whereas the probability of getting stopped out just under 745

was much greater.

True, a risk under 720 is much larger than the risk assumed just under 745.

However, if the position is going to be profitable, it will not go back under

720, so the likelihood of being stopped out at 716 is much lower than the

greater likelihood of getting stopped out under 745, and guaranteeing a loss.

In terms of market activity, price did go to 733 and stopped out a lot of

traders who thought they were limiting their risk, but demand came in and

held 733 without ever putting the stop under 720 in jeopardy for a moment.

Is a larger, initial market activity stop a greater risk than a predetermined,

smaller dollar amount?

No.

In fact, it makes more sense, and there is a much lower probability of a loss

than there is in the smaller dollar amounts put at risk. Those not willing to take

the real, defined risk in a market position are wrong to call themselves risk

takers.

They fail to understand the meaning.