Risky Business

Risk is fundamental to trading, unavoidable because it's necessary. However, not all risk is created equal.

Generally speaking, trading involves two types of risk: appropriate risk ("good" risk) and needless risk ("bad" risk). Going first with the worst, needless risk occurs when you enter into a position at a suboptimal area so that your stop is either unclear, exposes you to more loss than is necessary, or, even worse, you don't have a stop in at all. Moving over to the best, appropriate risk is:

a. Clearly defined

b. Minimal

Position size is also a key component of risk. Your trading volume (the number of shares per trade) should differ depending on each particular trade. Having too big a position on at any given time is reckless and can lead to needless losses, while having too small of a position can prevent suitable profitability. But figuring out the correct position size will allow you to strike an appropriate risk balance.

In a business where risk constantly dukes it out with reward, traders must practice a risk-first approach. What this means is that before entering a trade you must consider how much you can stand or afford to lose on the position instead of only thinking about how much you might make. Just like everyone who buys a lottery ticket is convinced that theirs is the winner, the undisciplined trader mistakes every trade for a "Cigar Trade". And what is a Cigar Trade? It's the kind of trade where the second you make it; you can put up your feet and light a cigar because you just know it's the one you can retire off of. But we get ourselves into untold amounts of trouble by ignoring the downside potential of a trade. In fact, one reliable piece of advice you can get from the retail investment firms that advertise on television is that clients must "consider risks prior to investing".

If we go into each trade knowing the dollar amount we'll lose if the trade works against us then we have the benefit of defined risk and can then begin to focus on profit potential. The key then becomes recognizing the types of trades that involve appropriate risk.

During a week in which the market plunged to depths not seen in more than two years, shipping giant FedEx (FDX) was an aberration, rallying more than $40 from low to high thanks to a strong earnings report before the market opened on Tuesday, June 14th. If you didn't see much opportunity to buy FDX on a day trading basis during its earnings inspired rocket ride (unless you just bought the news on the report), I can promise you that you were not alone. However, that doesn't mean that there wasn't eventually an opportunity to get short with appropriate risk and ample reward.

FDX made its high on the move at 239.21 in the morning on Wednesday, June 15th, its second day of gains, as indicated by the red arrow on the chart above. FDX formed up in a tight range around that price, which you could have taken advantage of for a short with a stop right above the high. In this case, the risk was minimal, but maybe not so well defined because you would have had to determine on your own where exactly the stop should be. On the one hand, you could stop yourself out just a few cents above the highs or decide to let it over-react through the highs and made your stop a bit higher. Either way, once your stop was in, your risk was defined and you were willing to accept the loss should it indeed have turned into one.

If you were not inclined to sell when it formed-up against the highs, FDX gave you another golden opportunity to get short with a brief form-up at around 238.70, as shown by the blue arrow on the chart. Here, you would absolutely stop yourself out above the highs, giving you a clearly defined 50-60 cent risk. On a 200-share trade, for instance, that's approximately a $100 loss, or "betting a ballgame" as we sometimes like to say. Should the trade have worked in your favor, you could have reasonably held the position down to support at around 230, which was the original highs from the previous day; and is exactly where FDX sold down to before reversing. 

All told, you had a potential maximum profit of more than $1,600 assuming a 200-share position against a maximum potential loss of just over $100. Identifying appropriate risk first, which was both minimal and clearly defined, provided an opportunity to get into a trade with a 16:1 profit to loss ratio! 

With Boeing (BA) we see an opportunity to buy with appropriate risk, even if we were not buying absolute weakness as there were potential areas down below where we might like to buy and lower areas of support as seen on this 5-Minute chart. Remember, appropriate risk means that the loss is both minimal and clearly defined, which will always be the case as long as we have the proper stop in place. BA double-bottomed at 132 (blue arrow) and then rallied nearly $7, to just about 139 before the end of the session on Friday, June 17th. Your stop would have been below the lows to the left of 132, at 131.30 (red arrow and circled). Based on our 200-share trade, the risk was defined at around $140, but the possible reward was almost $1,400; a ratio of 10X profits to losses. Here, it doesn't matter that the chart offers other areas of support and we're not going to be intimidated or uncertain of making a trade just because there were other prices on the chart at which to make trades. All that matters is that we had a strong formation in the double bottom at 132, and we had the proper stop in right below 131.30. Had BA worked lower after our stop, that would have simply been another trade altogether.

Notice how in each trade the hypothetical  position size was 200-shares. As discussed earlier position size is another facet of appropriate risk, as it will help to define and minimize your risk. Your volume from one trade to the next will be dictated by some combination of your personal liquidity, the price and volatility of the stock in question, overall market conditions, and the area on the chart from which you're entering the trade.

There are times when it makes sense to pile in to a trade at higher volume. But in the interest of conserving capital and reducing risk, smaller positions are advised, at least until confidence and greater understanding of the markets are cultivated. That said at profit to loss ratios of 10:1 and greater, you don't need a large position size to garner a handsome profit, and as we saw in the charts above, the profits can be realized rather quickly, within the course of a single midafternoon sell-off or rally.

Not to contradict the entire message expressed here, but sometimes it's appropriate to feel a trade out a bit, perhaps only putting a stop in for a portion of your position, and then speculating on the rest. This should be reserved for those occasions when the stock you are trading is in a particularly rare area or there is some other technical reason either with the stock itself or the market in general that compels you to stay with the position beyond your initial stop. On such occasions you may believe that covering completely will undermine an opportunity for a profitable trade down the road on the basis of a longer-term outlook or position.

At a time when the global economy and therefore the stock market is fraught with uncertainty, it may seem like risk is greatly amplified. However, if we approach each individual trade from a perspective of appropriate risk, it helps us to mitigate the market's dramatic ebbs and flows while positioning us to achieve maximum profits relative to any potential loss.