Risk Management: All About Risk
Nov 8, 2011 at 5:04 pm in Risk Management by
All About Risk
In trading circles we talk about risk a lot. But what exactly is it, how can we measure it, what can we do to avoid it or contain its effects, what should we do when it happens, and (hey!) can it be good as well as bad?
What is Risk, and How Do We Measure It?
In layman’s terms, risk is often taken to be the probability of something bad happening.
On spread betting platforms, risk often — and in the case of the Shorts & Longs platform, explicitly — is equated with the impact that an unfortunate occurrence will have on your trading funds; i.e. how much money you will lose if a trade goes bad.
So we have two possible definitions of risk: once involving probability and the other involving impact. And they’re both right, but each one is only half of the story.
In a previous life as an IT consultant I used to teach project management, one aspect of which was risk management. In the context of IT project management, and in many other disciplines including finance, risk is defined as:
risk = probability x impact
It’s a combination of the chance that something bad might happen, and how bad it will be when it does.
Some things are more likely to wrong, but when they do, it ain’t that bad. Some things don’t happen very often, but they’re pretty disastrous when they do. That’s why I don’t particularly like flying. I know it’s statistically safer than driving (if we consider only the probability of an accident happening), but unlike in a road accident the impact is higher because you will almost certainly end up dead!
If you bet the farm on a blue chip stock, the probability of it going bust is very small. But if it does, the impact will be that you’ve lost your shirt.
If you bet small on a penny stock, the probability of it going bust may be very high. But if it does, the impact will be very small thanks to your prudent position size.
What can we do about Risk?
You can also have a contingency plan — let’s call it ‘Plan B’ — that tells you what to do if a risk actually materializes. If one of my positions stops out at a loss, I put that stock onto my Stop-Out List with a view to re-entering at an even better price.
Actually, there are a few more things you can do about risks besides mitigation and contingency, including:
- Risk avoidance: by not trading at all.
- Risk reduction: to lower the probability of an adverse outcome, for example by ‘investing in’ blue chip stocks or always using wide stop orders that are unlikely to get hit.
- Risk acceptance: like a “buy and hold” investor does by holding all the way down to zero!
- Risk transfer: by guaranteeing your stop order in exchange for a fee.
Stop Orders and Risk Reduction
When it comes to placing stop orders, there is an interesting relationship between reducing the probability that you will get stopped out and reducing the impact that your stop-out will have.
The tighter your stop distance, the higher the probability that you will get stopped out with a small impact. The wider your stop distance, the lower the probability that you will get stopped out with a big impact.
With a perfect correlation between probability and impact, where a 50% closer stop meant double the probability of stopping out with half the impact, it really wouldn’t matter where you placed your stop orders. But the correlation isn’t perfect, because:
- The spread betting company takes the spread in any event, and the stockbroker or Contracts for Difference (CFD) company takes the dealing fee(s) in any event. So high probability / low impact tight stop orders are less efficient than low probability / high impact stop orders.
- Some stop levels are more likely to be hit, in a way that is not necessarily proportional to stop distance, for example where stop order levels correspond with support or resistance levels. So fixed-distance automated trailing stop orders that take no account of technical factors can be problematic.
In my view we should place stop orders in the right place with respect to technical factors like support and resistance levels, and then use position sizing to lessen the impact of stopping out.
A Positive Impact
It is tempting to think that risk is always negative, but this is not necessarily the case. There is a risk that something good will happen to you, like winning the lottery. You can consider the probability that this will happen, you can dream about the positive impact it will have on your life, and you can punch these numbers into exactly the same equation that I introduced earlier. It’s just that in this case the impact is positive rather than negative… but, unfortunately, the probability of this happy event is very low!
Those who practice risk avoidance, by not trading at all, are avoiding the positive (upside) risks as well as the negative (downside) risks. You’ve got to be in it to win it.
The Single Best Risk Mitigation Strategy
It’s a personal view, but I regard diversification as the single best risk mitigation strategy. By diversifying across many separate positions (and over time) I try to ensure that — whatever happens — no single bad trade can ever wipe me out. But if you think that playing the FTSE means you’re diversified, you can think again!
Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.