Search This Blog

Saturday, November 10, 2007

Money Management: Risk Analysis

Every human on the planet, engages in risk analysis every day. Chrysler offered Joe a job. Should he take the job? Will he be outsourced next year? Will his job move to another country? Will he be unemployed? Will the union help lower that risk?

It’s the same in this business. You have to determine your risk. You have to try to devise ways to try to limit that risk.

Let me say that again.

You have to determine your risk.

You have to devise ways to try to limit that risk.

Determining means – you have to sit down, and at least plan out a reasonable worst case scenario. How much money would you lose. How much of your account would that loss represent? How would that impact your ability to trade further?

You have to figure any methods at your disposal to limit the risk. For example, I recommend never, ever putting more than 3% of your total account size, into one trade or investment. Some people will say 2%, but I raised it to 3% due to what I will talk about next. Reward. Open-mouthed Regardless, the number has to be very low. When you are very experienced, you can raise that number to perhaps 5%, if the situation is right. However, again, it must be low. Why?

It helps mitigate your risk. Thus, you become someone engaged in business, rather than gambling on your money in one area. With only 3% of your account towards Ford? If Ford tanked and went out of business tommorrow, that would only represent a 3% loss to account size, which is your business. Your risk is mitigated. You are left to trade another day, and one disaster doesn't sink you.

That means also, that you must do something that most traders fail at. Have an adequately funded account. An underfunded account is one of the FIRST No-no's, when it comes to trading. This is only logical. Let's face it, if you only have $1,200.00? Then 3% of your account is $36.00. And who can initiate a trade with a risk total of $36.00? Commissions would eat that up, and I can't think of a trade vehicle where the risk is TRULY limited to $36.00. Options maybe. But they'd have to be so far out of the money, that your reward would be nill.

So having an adequately funded account, and keeping your risk per trade to 3%, helps your keep the rest of your account available for other trades. You won't miss business opportunities, because you had your money all in one area.

There are other ways to mitigate risk. Options. Options LOCK IN your total loss, at the price you paid for the option. Of course, Options come with their own risk that you have to consider. Part of the value of an option, is the time decay. As well as the volatility of the market. If your strike price is too far away, if the market isn't volatile enough? The market could slowly move in the direction you thought it would . . . but the option theta (time value) ticks away, and volatility remains low. Your option won't rise much in price.

Again, it comes down to determining your total risk. And trying to figure out strategies that mitigate that risk. There are many.

But there is a dark side to risk analysis that I will talk about in my next blog entry . . .

Search Investing and Trading Articles and Products