Risk Management

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Making adjustments to positions goes hand in hand with risk management. In the previous chapter, we saw how to adjust a winning position based on changing circumstances. Sometimes, however, we are forced to adjust losing trades. This can mean exiting a position at a loss, which is not always an easy thing to deal with. In fact, studies have shown that the emotional pain and stress from a loss is greater than the emotional lift received from a winning trade. In order to avoid the pain from losses, we obviously want to develop a game plan that generates more winners than losers. We also want to use strategies that have high potential rewards with relatively limited risk (those strategies have been covered earlier in this book). Another important consideration is risk management—understanding what needs to be done in order to limit the number of losses and, more importantly, limit the percentage lost relative to the portfolio’s value. This is ultimately a personal decision. No one else can tell you how much you are comfortable risking on one trade, in one week, or on one position. There are no hard and fast rules about risk tolerance. Nevertheless, managing risk is a key part of any trading plan because all traders deal with losses. In fact, some very successful traders will tell you that they are not great traders; they are great risk managers. Risk management helps remove the emotional responses that sometimes lead to irrational decisions. This chapter explores some strategies that will help you become more proficient at this very important aspect of trading.

OVERVIEW

No market approach is complete without a discussion of money management, which includes personal financial management. The topic can be all-inclusive, covering each step along the way from financial planning through managing an individual trade. It can also cover different types of investors and traders. Our primary focus is money management for indexbased trading, but many of the same principles apply to a variety of trade approaches. We begin with a brief discussion of asset allocation and risk management as it applies to investors, but we focus on trade management. We examine diversification and why it is important and then close out the chapter with a discussion of risk management as it applies to index trading (see Figure 14.1). An individual needs to consider several factors when making a decision about which markets to invest or trade in. There are several markets to choose from—stocks, bonds, precious metals, energy, real estate, foreign exchange, and so on. Ultimately, the decision is guided by several considerations, including the individual’s (1) knowledge of those markets, (2) total assets available, and (3) risk tolerance. Since this financial markets decision is based on highly personal factors, it is up to each individual trader to determine which markets are most appropriate. Knowledge of the markets is obviously important and reading books like this one is a good first step. More importantly, new traders will want to track the market to get a feel for it over time.

Different financial markets can behave very . . . well, differently. In addition, market conditions change over time. The more hours spent studying and observing a market, the better the knowledge base in which to begin. In addition, traders must also decide whether to invest in a specific market or to trade it. A general rule of thumb is to trade only one or two markets at a given point in time, which will allow sufficient time to analyze and monitor conditions. It is very difficult to study and trade more than two markets simultaneously. As an example, an investor might choose to trade stocks and options. For most investors, there are simply not enough hours in the day to try to trade stocks, bonds, futures, foreign exchange, and the options market all at once. Our discussion of risk management focuses on the U.S. equity market, looking at important elements that relate to both investing and trading. While these general concepts can be applied to other markets as well, the reader must be sure to understand the unique risks and characteristics of any given market. Each market is different and offers varying risk/reward opportunities. For now, our focus turns to risk management in the U.S. stock market.

Cash Is King

Maintaining some cash on hand never hurts. Readily available cash provides ammunition for that sudden, unexpected trading opportunity. More importantly, it can serve as a cushion or buffer in one’s portfolio. In that respect, cash can help reduce the stress associated with having an entire portfolio invested in the market—particularly when large declines are encountered. Cash should be held in interest-bearing accounts, such as money market funds.