Understanding Trading Risks Is Crucial For Your Success
InvestorEducation / Learn to Trade Sep 03, 2019 - 04:54 PM GMTBy: Chris_Vermeulen
This article will most likely open your eyes and see a side of trading you usually don’t think about or possibly don’t understand, even though it is critical for your long term success as a trader and investor.
Not many people talk about trading risks and for a good reason. It’s not that exciting to most, and its a real sobering topic because its the reality of trading: trading is risky, and that you need to know how to manage risk appropriately and we don’t know how to do this. Most of us are generally too lazy to want to learn dry/boring subjects, especially when we don’t know much about them in the first place, and I’m guilty of this as well.
I urge you to take 4 minutes and read this trading risks explained in laymen terms below. At worst is a good refresher and will make you look at your current positions and see all your capital carries the same risk and if you are positioned for steady growth or potential account implosion if the asset class moves against you.
Understanding Trading and Investing Risk Types
RISK
noun
· 1.a situation involving exposure to danger: “flouting the law was too much of a risk” synonyms: possibility, chance, probability, likelihood, danger, … more antonyms: impossibility
verb
· 1.expose (someone or something valued) to danger, harm, or loss:
There are many ways to define risk and different, disparate types of risk depending on investing in a home, doing business with a bank or investing in stocks, bonds, ETF’s, mutual funds, etc.
We know inherently, given my last week’s piece on the increasing amount of foreclosures occurring in the largest cities in the US, where housing has been robust, cities like San Jose, CA, San Francisco, Phoenix, Chicago, etc, that there is currently increasing risk in purchasing real estate at lofty prices and hoping that the market stays hot; that if you had to resell the real estate in the next few years one could get out at a similar price to the purchase price or even higher.
Given that we are towards the end of a boom housing cycle, this is probably not a reasonable risk to take, unless of course, one would be in it for the long haul. We call this liquidity risk or also buying an asset at a very high price as compared to its historical prices in a given market.
Another risk is if an investor, flush with cash, sat in cash and inflation were to take off or the price of goods and services continue to increase even without rampant inflation. This risk would be defined as purchasing power risk and puts the investor (or holder of cash) in an undesirable position of having their money NOT grow while the cost of goods and services around them grows. This can and does occur even if we are told that inflation is flat.
How does purchasing power risk show up? Look at the cost of food in the past few years. How much does it cost to feed a family today? When one has investable cash and does not keep it up with the increasing costs of “living,” this is the real definition of purchasing power risk.
If on the other hand, an investor decides to enter into the bond and stock market and invests in the wrong asset class, this is the best-known risk defined as asset class risk. One invests in the fixed income markets, and rates go up and while the coupon may stay the same the principal amount of the investment goes down.
Likewise, someone decides to invest in technology stocks, and they go through a correction or decline, then that sector goes down, and one’s investment is negatively impacted. This is a sector or industry-specific concentration risk.
Another potential risk asset class or even sector-specific risk is if someone decides to invest only in small-cap stocks because they like the growth rates, and this area of concentration is enticing. However, there is an inherent risk:
a) interest rates go up which puts pressure on smaller companies;
b) the economy goes into a downturn and these stocks lose value and
c) most importantly, they want to get out of these stocks at some point (perhaps due to a and b above) and they cannot get out at a fair price because too many people are selling and there is not enough volume in the stock.
Then the problem for the small-cap investor may be getting out of these thinly traded stocks when the correction ensues. This is known as liquidity risk and can have a detrimental effect on the original portfolio value.
Perhaps one decides to invest in stocks and decides to appropriately diversify their investment into a longer-term buy and hold strategy and does so with high quality, dividend-paying stocks. This seems like a reasonable investment thesis and one that both institutions and individuals participate in every day.
However, what happens when we go through normal corrections or even enter a bear market and have a steady trending downward market. What does one do? Buy more as the stocks are going down? Wait until they seemingly bottom and then put more $ to work? We call this market and price risk, and it is from having $ invested in a down-trending market with no clear plan of getting out and not being sure of what the targets are that one should exercise to get out.
Then, as an investor playing in a professional market, you always have knowledge risk and unforeseen surprise risk. Knowledge risk is not knowing the “full” story and investing in a company that you may know little about and what the forward earnings projections are. Some that come to mind in recent time is GE, XOM, BBY, JCP and many others that seemed like very good, quality companies only to announce reorganizations, problems with their business or worse, potential bankruptcy.
The unforeseen surprise element, while similar, includes accounting errors (WorldCom), corruption (ENRON), and other factors that an investor may have little to no knowledge of.
Other investors like to trade and invest where they have little or no knowledge in emerging markets like Russia, China or Brazil only to surprised when political upheaval, slowing economies, currency risk or other factors can and will hit these markets hard and decimate speculative investor capital.
Investing in individual issues or sectors like marijuana stocks, biotech stocks, and country ETF’s can be treacherous and best left up to professionals and analysts who cover these companies, industries, and markets.
Very important facts about investing:
If you lose 10% on your investment capital, it takes at least 11% to get back to even
If you lose 20%, it now takes 25% just to get back to even
If you lose 50%, it takes 100% just to get back to even
Facts About Growth:
FIFTEEN 5% WINNERS = 107% ROI
$500 PROFIT PER/MONTH = 30% ROI WITH $20K ANNUALLY
POSITION SIZING = TRADING SUCCESS
Technical Traders strives to accomplish critical things:
ONE: Make it easy for you to follow our trading suggestions and take the trades. We refrain from using exotic and hard to understand instruments, stocks, or ETF’s that are not readily available and have sufficient liquidity.
In other words, we trade things that we can enter (buy) and exit (sell) easily and quickly and do not depend on us getting an exact price. If we take the trade we usually get our order filled within a few cents from our original suggestion, by design, the trade can earn a significant profit. It does not depend on split-second timing like many other trade alert newsletter services.
TWO: We are very strict and very aware of position sizing. This is ONE of the most important ways to manage our risk and put the trader/investor (YOU) in a position that if the trade does not work, it will not hurt the overall portfolio too much and, more importantly we typically diversify with other positions at a similar time which diversifies the portfolio and allows you to reap the rewards from other disparate trades.
THREE: We have a set goal in mind when we put on the trade. These are well-defined targets as well as STOPS. If the trade works, we know where it is headed and what we will do along the way, usually resulting in taking off part or all of the trade with our targets being reached. If the trade does not work, we are out rather quickly with minimal damage to the overall portfolio.
FOUR: We always back up our rationale for why we put on the trade. One only need to watch our pre-market daily videos to get a view of why the trade set-up is occurring and what our expectations of the market are.
FIVE: We trade in a wide variety of markets and with a wide variety of instruments, mostly ETF’s that are 1x, 2x, and 3x leveraged.
If we have a strong conviction about the trade or a limited amount of capital left to put into a trade, we would instead use a levered 2x instrument, or 3x occasionally because we want to capture the move with some extra juice (leverage) to hit the target and get out. Many of our subscribers have seen us go into SSO or SDS inverse SP500 ETF’s for a day or two turnaround in the markets and experience a 1-3% move. We typically get out on those trades quickly, and YOU have benefitted from the use of leverage.
SIX: We like small but quick winning trades knowing that this helps compound wealth in the portfolio. Are you aware that short cab rides (or UBER) are much more profitable for the driver than all of the long runs, say to the Airport? Making a quick profit from a few swing trades lasting 2-20 days over and over is much more profitable than taking a long-term position. Nothing more frustrating than watching a long term position you have had for months or years turn south and give up all the profits. Months of mental stress and risk on your portfolio for little to no gain. Not our cup of tea.
SEVEN: We minimize Risk and Utilize Capital efficiently by making precision trades that have a high outcome of success and keeping our powder dry (in cash) while waiting to take advantage of optimal technical set-ups consistent with our approach of finding markets that present an excellent opportunity. If we have high conviction, then we may recommend you use a 2x or 3x levered ETF instrument with ample liquidity to get in and out of the trade. Examples of these would include our recent trade on SDS 2.5% (2 days), UGLD 24% (2 weeks), and plenty of others.
Please note that our suggested ETF trade recommendation portfolio from January 1, 2018, to June 30, 2019, produced a 70% return, non-compounded and close to a 100% return if you compounded the trades.
However, we did so on a capital base of approximately 50%. Meaning, that we took probably half of the risk a similar, fully participating portfolio in the market (buy and hold) might take. Our capital efficiency was extremely high since we were sitting in a safe asset class, about 50% of the time without incurring risk. Most of the time, the whole portfolio might have been 100% in cash when there was too much uncertainty, and trends were changing.
Factor in that there were occasions when we only had 25% or 50% invested and other times when we were fully invested. We guess that we were sitting in cash with part or all of the portfolio upwards of 50% of the time. That also means that we had a BETA of 0.5% to the market (for you technical gurus), and a return on equity probably close to 150% on invested capital during that 18 months which factors out to risk to about 1/3 to ½ less than an S&P 500 index fund, and an ALPHA so high it would be off the charts and our telling you what it is would be far too boastful.
I hope this detailed explanation of risk has helped you see risk in a new light and just how vital risk and position sizing are to the long term growth of your trading and investing account.
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Chris Vermeulen
www.TheTechnicalTraders.com
Chris Vermeulen has been involved in the markets since 1997 and is the founder of Technical Traders Ltd. He is an internationally recognized technical analyst, trader, and is the author of the book: 7 Steps to Win With Logic
Through years of research, trading and helping individual traders around the world. He learned that many traders have great trading ideas, but they lack one thing, they struggle to execute trades in a systematic way for consistent results. Chris helps educate traders with a three-hour video course that can change your trading results for the better.
His mission is to help his clients boost their trading performance while reducing market exposure and portfolio volatility.
He is a regular speaker on HoweStreet.com, and the FinancialSurvivorNetwork radio shows. Chris was also featured on the cover of AmalgaTrader Magazine, and contributes articles to several leading financial hubs like MarketOracle.co.uk
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