At the heart of all trading and investing is the relationship between risk and return. The only way to produce more substantial gains is to take on more risk. The essence of trading is to look for situations where you can contain the level of risk while maintaining the potential for substantial gains.
Ideally, traders want to find asymmetrical situations where the potential reward greatly exceeds the risk of loss. The problem is that it isn't easy to quantify the exact level of risk or reward. It is very easy to misidentify both.
Rookie traders have a tendency to take 'coin flip' trades. Rather than address the risk they are taking, they hope that Lady Luck will smile upon them and reward them. This can work pretty well at times, but it will inevitably lead to painful losses when market conditions turn.
There are three basic ways to manage luck. The best traders use all three in varying amounts. Here they are:
The primary risk management tool of traditional Wall Street is fundamental analysis. The idea is that if you can determine the 'true' or intrinsic value of a stock, then you will be protected because the market will recognize value over time and will accurately reflect it in the price of a stock.
This seems like a pretty logical concept, but there are a number of problems. First and foremost is that the market can go for very long periods of time when it fails to recognize the true value of a stock. As the famous dicta goes, 'the market can remain irrational far longer than you can remain solvent.
Even if your fundamental research is stellar, there is no guarantee the market will embrace it. What is even more dangerous is that fundamental research is often badly flawed and will provide false comfort about the real level of risk.
The biggest losses that most traders will ever suffer occurs when they incorrectly assume that a stock is fundamentally sound and they build excessive large positions as it trades lower.
Fundamental research will help you identify a situation where there is a great opportunity, but as a risk mitigation tool, it can be extremely dangerous.
Another way to handle risk is by limiting your time frame. Generally, the shorter your time frame, the less your level of risk. This is the basis for much of what day traders do. If you don't carry a position overnight, then you don't have nearly as much exposure to surprise news or a shift in market conditions.
The problem is that shorter time frames also limit your potential reward. You will catch movement due to ordinary intraday volatility, but big gains usually occur overnight or as a meaningful trend develops.
The key is to find a time frame that isn't so short that you miss out on gains but isn't so long that you take on too much risk. One solution is to simply avoid holding into news events such as earnings or FDA decisions.
Finding the time frame that works best for you is one of the keys to managing risk. I tend to trade in a wide variety of time frames of varying sizes which is one of the many ways I deal with risk.
A third way to manage risk is to focus on price action. A very disciplined trade management system controls risk better than anything else. When losses hit a certain level, then sell. When you have a certain level of gains, then take some profits.
You can use stock charts in a wide variety of ways to provide a road map for risk management. You might use moving averages or areas of congestion on a chart to be your guide. The key is that you be systematic and disciplined in the application.
The excuse that many traders use for ignoring money management rules is that the market is not accurately reflecting fundamentals. They feel that the fundamental analysis will keep them safe while the market is acting irrationally. That may work, but it also means that your risk of being wrong is much higher.
The Combination Approach
The best approach to risk management combines fundamental analysis, time frames, and technical analysis. Much of what I do on a daily basis is trying to balance all three elements as I trade a stock. My fundamental research helps me develop my level of conviction. Using a variety of time frames will help me control risk and provides a form of diversification. Technical analysis provides a framework for when to sell and when to buy.
Unfortunately, what works best will constantly change based on the stocks that you are trading and market conditions. There is no optimal set of rules that can be applied which is why we must always be vigilant when managing trades.
Many traders never fully embrace the relationship between risk and reward. It remains a vague notion and isn't dealt with in a systematic way. Trades are nothing more than hope when you don't address the risk that you are taking and how to limit it.
The relationship between risk and returns is at the heart of all speculation. If you want the big returns, you have to be willing to take on more risk, but that doesn't mean that you can't develop ways to produce better odds.