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There are times in the markets where risk management is far more important than profits, keeping the capital you have safe more important than growing it. I believe this is one of those times with volatility growing, uncertainty increasing, and many types of traders seeing profits evaporate and losses mount quickly. This is a great time to look at all the types of risk we must manage as traders. It is not just about stock picking it is about protecting your account from destruction as we chop around and try to find some patterns and trends in the current environment. If you don’t know what to do go to cash, it is at times the safest position. Here are the many faces of risk:
Here is an excerpt from my book New Trader, Rich Trader about all the types of risk that a trader has to deal with.
You have the basic risk that your trade will be a loser. This is trade risk; however you can control the maximum amount you lose in the majority of situations through position size and a stop loss.
You also have the general market risk factor. You can pick a stock of a wonderful company but if the trend of the stock market itself is down for whatever reason, the likelihood is that your stock will also fall regardless of the fundamental merits of the company or the past strength of your stock’s price movement. The market is like a tide that comes in and lifts all ships and then goes out and lowers them back down.
You have the risk of your stock either being or becoming highly volatile. Volatility risk can scare you into selling your stock too soon or simply cause your system to stop working because the stock you bought hit your predetermined stop loss and forced you to sell – even though it might reverse and be right back where it started later that same day.
Overnight risk is when something unexpected happens when the market is closed and the next morning your stock gaps down in the pre-market and you never even had a chance to sell and stop your loss. This risk applies to everyone except day traders or traders who trade markets that are open 24 hours on most days
Liquidity risk is when there are just not many buyers or sellers for your stock so you lose money in the bid/ask spread. The “bid” is what a market maker is willing to buy your stock for, and the “ask” is what they are offering to sell it for. There are stocks and options that have such low volume that you can lose 5%-10% just simply buying and selling, even if the stock price does not move. If your stock has a BID $9.50 and ASK $10.00 and you buy it at the ask price then sell it at the bid price, you lose 5% when you enter and exit the trade. It is important to trade in stocks that have a small spread in the bid/ask quotes. Less than 10 cents is good but a penny or two is excellent.
Margin risk is when you use your stocks as collateral and borrow money from your broker to buy additional stocks. Most brokers, after you have set up a margin account, will allow you to buy additional stocks and double the size of your account. With margin you can use a $10,000 account to buy $20,000 worth of stock as long as the stocks are marginable securities. Some more risky penny stocks and small cap stocks are not marginable. The good thing about margin is you make twice as much profit when you are right, but the risk is that you can lose twice as much if you are wrong. Doubling your risk with margin greatly increases your risk of ruin by making your losses compound twice as fast!
Earnings Risk: If you are holding a stock through earnings, you are exposed to the risk of a sharp move in one direction after the announcement. It can hurt your account if the move is too fast after hours and blows through your stop loss.
Political Risk is a possibility if you are invested in a company located in a different country or your stock’s company does a majority of its business in a country that suddenly has a change in power. Investors and property owners of all kinds were wiped out when the Communists took over all private property for the state in Cuba in 1960.
Time decay risk: If you trade options, the clock is always ticking against you. A major component of a stock options value is its time value: each day it loses a small amount of this value until it is only worth its intrinsic worth of how much it is ‘in the money’ based on its strike price. So if you decide to trade options, realize you must be right about the price movement and the time frame. You are also paying for the right to control the shares, so you have to be right by more than the cost of the option for it to be a winning trade.
There is also the risk of error where you can actually put one too many zeroes on the amount of shares you want to buy for a trade, or buy the wrong symbol, or sell a stock short instead of buying it long. Double checking your trades before you place them is very important.
One of the most frustrating kinds of risk of all is technology risk. If trading is not hard enough already, you can also have your Internet connection crash or your broker’s trading platform go down while you are in a trade. These are good reasons to have a backup plan like the phone number for your broker ready at the push of a button to get out of a trade entered. Anything can happen while you are trading, so be prepared.”