Tuesday, August 08, 2006

Winning entry to the writing contest

This is the winning entry for the writing contest. As you can see, it is quite a production. Thanks to everybody who participated!

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Risk management

By Terry Zink

“You get paid for taking risks.” This one phrase is critically important to understand if we want to make money in the stock market.


What do we mean when we say we get paid for taking risks in the market? I believe we can understand it thusly: buy before you are certain and sell before you are sure. To put it another way, our returns our better if we act before all uncertainty has cleared.


Risk and uncertainty are two terms that are often used interchangeably. When we say that we are paid for taking risks we are usually referring to uncertainty. Uncertainty is the probability that an investment we make will work out positively for us. If we make an investment whose outcome is uncertain, we will typically expect a higher rate of return. If the outcome cannot be predicted with a high degree of certainty then it makes sense to look elsewhere where the outcome is more predictable. However, if the potential payout is higher, then some investors are willing to overlook that uncertainty in order to maximize return.


Logically, it makes sense that the more uncertain the outcome, the more potential return we ought to expect. If we have to pay a price for uncertainty then we should expect to get more if it works out. In the bond market, long-term bonds have (or should have) higher rates of return than shorter term bonds. The reason is that longer term bonds ties up a person’s money for a longer period of time, and a lot of stuff can happen in that longer time period. It becomes more and more difficult to predict what might happen as the passage of time progresses. Thus, the price of tying money up longer is a higher rate of return.


In real terms, how might we quantify uncertainty? It is unfortunate that risk and uncertainty are often used interchangeably, for while risk is measurable, uncertainty is not. So, how might we go about measuring risk? In practical terms, I believe we can define risk as the most amount of money we are likely to lose in the case that trades or investments do not proceed the way we planned. For example, if we were to invest in a stock, we might define the maximum amount of money we will allow ourselves to lose is $500 before closing our position. We would then call this our risk, or to put it another way, we risk $500. If we invest in real estate, we might say that the most we will be willing to lose on the property is $10,000 before we sell. In either case, the amount we risk is the most we would be willing to lose before closing our position and cutting our loss.


Risk is closely correlated to reward. In all investments we must always ask the question “What is the risk/reward ratio?” The risk/reward ratio, conceptually, is evaluating how much money we think we can make versus how much money we will allow ourselves to lose. If we believe that our potential reward is considerably greater than our potential risk then we have a favorable risk/reward ratio and the investment is probably a good one. How favorable the risk/reward ratio ought to be depends on the individual investor, but in any event, it had better be less than 1.

Using this concept of defining risk, the phrase “you get paid for taking risks” might be better stated as “your payouts are better when you act before all uncertainty has cleared.” We use various tools to guide us in our decision about whether or not to act, including fundamental or technical analysis, or a combination of the two.


The risk/reward ratio is one of the most important ideas in investing, because an analysis of the risk/reward ratio often answers the question of whether or not a potential investment ought to be made. It also can help eliminate the uneasiness associated with uncertainty. When it comes to uncertainty in the market, an investor will often want to predict whether or not the investment will work out. By analyzing the risk/reward ratio the investor need not predict whether or not an investment will work out, he (or she) can weigh the facts and a decision will naturally present itself.

Let me create an example. Suppose an investor is trying to decide whether or not to take a position in a stock. They really don’t know if the stock will go up or down. Let us assume that the stock has been trading in a range between $40 and $50 per share for two years. The stock is now at $48 per share. Should the investor buy the stock? We know the stock usually hits $50 and bounces down, that means it has $2 to go before it probably turns around and trends down. There is not a lot of room on the upside, but plenty of room on the down side. We could only let the stock go down to $46 for a risk/reward ratio of less than 1. That is not a lot of downside room. A tighter stop might be $47 for two-to-one odds, or $47.50 for four-to-one odds, but that is not a lot room as stocks can fluctuate that much in a single day. Indeed, this is not a great risk/reward ratio. If the stock were trading at $41 or $42, we now have a lot of upside room and we can still set a $1 or $2 stop that gets us out. Note that in this case, we didn’t need to worry if the stock will break out of its trading range, the risk/reward ratio ruled out the first case but left the door open for the second.


What are some real life examples of taking risks in the market? One is taking action in a potential head and shoulders top before the change in trend has been confirmed. Figure 1 is an example of a stock in an uptrend, bouncing up along the trend line along subsequent rallies and pullbacks. However, at point 1, it pulls back and breaches the trend line it had always successfully held. It makes a successive rally at point 2 but fails to attain the high of the previous rally. At point 3, it closes below the low point of the preceding pullback. This is a confirmed change in trend from up to down. At that point, traders might decide to close their existing positions or go short on the stock.



Figure 1 - Confirmed change in trend

Note that we must wait for the stock to close below the previous pullback low. Is this the optimal time to close the position? While the trend has confirmed a change from up to down, we have given up a good proportion of our potential gain. After trading costs, commissions and slippage, waiting for consummation of the down move can wipe out a significant portion of our potential profit.

Instead, we might decide to go short around the peak of a right-shoulder in a potential head and shoulders top. If we can see that an uptrend has been violated and the successive rally fails to clear the high from the previous one, we can act before we are sure that the trend has reversed. All uncertainty has not cleared, the previous pullback support level has not been violated but the return will be greater if we capture as much of the move as we can. This is illustrated in Figure 2. The up trend has been violated at point 1 and the subsequent rally at point 2 has failed to carry up to the high of the head. At point 2 we have a potential head and shoulders top and we can take action by closing an existing position or going short. We do not know if the trend will be confirmed but our return will certainly be greater by acting sooner rather than later. We then minimize our potential loss by clearly defining how much we are willing to lose before we conclude we are proven wrong. We might incorporate some technical analysis that will prove us wrong, or use a volatility reversal against our position, but in any case, we manage uncertainty by defining our risk.



Figure 2 - Possible head and shoulders top

Another example is at the end of bear markets, fear is rampant and investors are hesitant to go long in the market for fear of losing more money. This is a justifiable fear; nobody likes to lose money and the reason we buy stocks is because we expect them to go up. However, even bear markets come to an end. There are numerous systems that produce signals to get back into the market, and the earlier we get into them, the better our potential gains. The problem is that hesitation can come into play for fear of the market reversing again and shaking us out of our positions, netting us another loss. We can wait for the market to provide us a clearer signal but by the time that occurs our potential returns have been reduced. Again, adding in commissions and trading fees, not to mention slippage, our potential returns are shrinking the longer we wait. We must act before we are certain, and we manage our risk by clearly defining how much we are willing to lose.


In trending markets, we must keep in mind that the longer a trend has been in existence, the closer it is to its end. Thus, we need to have faith in our market analysis when it is telling us to get back into the market and we then manage our risk to keep us in the game in the event we are proven wrong.


This illustrates the concept of minimizing our risk vs. managing our risk. Minimizing our risk would certainly guarantee the probability of a positive outcome but that outcome would be quite small. By comparison, managing our risk is accepting that we don’t know for sure how an investment will turn out, we accept that fact, but we go ahead and do the investment anyways because we can potentially make a substantial positive return; we will close that position if we lose money according to a predefined condition.


There are several systems of managing our risk, one of which is diversification. Diversification is the practice of investing in numerous different industry groups; when one industry group goes down the losses are offset by the gains in another. Thus, a large loss in one can be counter-balanced by another. Diversification is not limited to investing in a broad number of industry groups, however. A smaller concentration of industry groups may be invested in with a specific amount of total capital risked for each trade, say 1%. A method that concentrates in high performing industry groups but limits itself to a few individual positions manages risk by avoiding overexposure to a major downturn in any one group and protecting total trading capital. Indeed, the protection of initial capital is crucial to managing risk; it takes a larger proportional gain to make back what you lost. For example, if your capital drops 10%, it requires an 11% gain to break even. If your capital drops 25%, it takes a 33% gain to break even. Thus, selecting strategies that protect trading capital is a method of risk management that is imperative for any speculator to make use of. Note that we have not necessarily dispelled any uncertainty but we have minimized our potential loss if conditions move against us.


Of course, no system of risk management is perfect. Acting before we are sure has its downsides, as markets can quickly reverse with little to no warning. Sometimes the moves that we anticipate would happen don’t happen after all. Fundamental news changes can drastically alter the decisions we would have made had we had access to that news. If we buy a position in a stock and plan to get out if we lose 5% of our original position, that assumes that we actually can get out before the 5% has elapsed. What if we buy the stock and the next day the company declares bankruptcy and the stock goes to zero overnight? What if we are short the stock market and the Federal Reserve decides to cut interest rates from 5% to 1%? What if we buy a California-based home builder and the next great earthquake hits and California breaks off from the continent and submerges into the sea? Indeed, all of these sudden changes in market conditions can hurt us much more than we planned. Our risk management system breaks down.


But even in these cases, it is not as bad as it sounds. While these sudden changes are possibilities, they are not probabilities (except for perhaps a sudden change in policy from the Federal Reserve or political decisions by government). It is a possibility every day that we may get into a car accident but most people still drive cars to go to work. We can get food poisoning from contaminated food but most of us rarely think about this in the food we buy from the supermarket. They are possibilities but not probabilities. We make decisions based on the most probable outcome and take the necessary steps to minimize our risk. In the case of a car accident, we can fasten our seatbelts and buy cars with airbags. With supermarket food, we can buy canned goods and wash our vegetables. In the market, we can allocate only a portion of our trading capital to any one position and define our exit criteria. None of these will protect against the absolute worst case but it manages risk and, in this case, reduces it. It is a matter of taking steps to minimize the damage in the event that we what we don’t expect to happen, happens.


Risk management, then, does not involve eliminating risk but instead managing it by accepting what might go wrong and how to prevent damage that can occur. It is a matter of making intelligent decisions on how to allocate capital and taking action before certainty becomes completely known. Any mediocre trader can become an excellent trader by incorporating risk management into his or her methods.

5 Comments:

At 10:14 PM, Anonymous Terry Zink said...

This article is a reflection of my own personal trading experiences as well as pulling together many of the ideas from some very gifted writers that I have read.

Reading articles by other traders has helped my own trading tremendously. I'd like to thank Jon for reopening this contest and giving me the chance to organize my thoughts and get them down in cyberspace.

If anybody would like to email me, I can be contacted at tzink@frontbridge.com.

 
At 2:17 PM, Anonymous Richard said...

I enjoyed the article, but I have a question:

The article defines uncertainty as the probability that an investment will work out. Then it says that it's logical to expect a larger return when we accept more uncertainty. Then, it says that uncertainty is not quantifiable.

The last sentence does not appear to be consistent with the other two. Or am I missing something?

 
At 6:21 AM, Anonymous jeff said...

I enjoyed the article. Time well spent.

 
At 12:19 AM, Anonymous Inventory POS System said...

I like your article and it really gives an outstanding idea that is very helpful for all the people on web.

 
At 12:22 AM, Anonymous Inventory POS System said...

I like your article and it really gives an outstanding idea that is very helpful for all the people on web.

 

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