Clicky

What is Risk Anyway?

Posted By Robert On Wednesday, December 11th, 2013 With 0 Comments

In simple terms, risk is the amount of money that you stand to lose (i.e. the impact) if a trade goes wrong. A £1-per-point bet on a stock index priced at 5000 notionally places £5000 at risk, regardless of the spread betting company asking you to put up a much smaller amount to open the trade. But you know that stock indices do not generally “go bust” and so you assess the probability of a total wipe-out to be a mere 1%. Arguably, you could calculate a notional value-at-risk can be calculated as £5000 x 1% = £50.

Obviously there are a range of possible outcomes, like the probability of losing half of your money if the index halves in value, but stick with me and my total wipe-out scenario for the sake of argument.

By placing a guaranteed stop order at 100 points below your buying price, you can reduce your worst-case monetary risk from £5000 down to just £100. But with (let’s say) a 50% probability of getting stopped-out on the more-likely-to-occur 100-point price fall, your notional risk would come out the same at £100 * 50% = £50.

Don’t take these calculations too literally. I’m just introducing you to the idea that true financial risk (and any risk) may be calculated as:

risk = probability * impact

Events that have a high likelihood of occurring, and which will have a devastating impact if they do, are very risky; like betting the whole farm on a company that might be in the process of going bust. In this case you need to reduce the risk by either a) reducing the probability of an adverse outcome by choosing a more stable stock, or b) reducing the impact of an adverse outcome by staking a small fraction of your available cash.

Risk Cuts Both Ways

This might surprise you, but true financial risk also includes the possibility that something “good” might happen. The penny share that has a 50% probability of going bust might also have a 50% probability of doubling in value… or more. And the more you stake, the bigger will be the positive impact on your cash balance if it does, according to the same calculation:

positive risk = probability (of a good event) * impact (dependent on the amount you staked)

Before you go betting the farm on that penny share tip after all, let me bring you back down to earth. If ever you bet the farm, and you lose, then it’s Game Over. Regardless of the potential glory, your main priority at all times must be to “stay in the game”. Look after the downside risk and let the upside-risk take care of itself.

What to do About Risk

In the simplest terms there are two things you can do about risk:

  • Lessen your exposure to risk through mitigation.
  • Have a contingency plan for when a risk materializes.

Mitigation

Given what I said earlier about risk being a product of both probability and impact, you can mitigate risks by:

  • Reducing the probability of an adverse event such as a price gap, by only betting on highly liquid indices and major currencies rather than penny stocks.
  • Lessening the impact of an adverse outcome by using prudent position sizing or by applying stop orders.

The irony with stop orders is that the tighter the stop, the higher the probability of taking a loss but the lower the impact will be. So there is an inherent trade-off between probability and impact when deciding on stop distances.

Contingency

It’s all very well trying to reduce the probability of an adverse event, and lessening the potential impact, but what will you do if the worst does happen? What is your contingency plan?

If one of your big bets goes sour and takes your entire account balance with it, will you dust yourself down and try again or will you skulk off back to the day job with your tail between your legs? Actually, this may not be such a bad idea, but on the assumption that you’ll try again, let’s consider another scenario.

When one of your positions stops out at a loss, when would you consider re-entering the same position? When the price starts rising again (thus risking a second “whipsaw” loss) or only if the price falls even further (which is my favourite, but that day may never come)?

Other Ways to Manage Risks

If you read a book dedicated to risk management, which will surely send you to sleep, you will discover that there are at least three more ways of managing risks:

  • You might avoid the risk by not spread betting at all.
  • You might accept the risk by buying and blindly holding your positions… possibly all the way to zero.
  • You might transfer the risk, for example by applying a “guaranteed” stop order to your bet.

Oh, heck, I just thought of another one. My personal favourite risk management strategy is to…

Diversify the Danger Away

Guaranteed stop orders can be useful when they are available, when the costs are acceptable for the protection being afforded, and when the minimum stop distances do not cause the protection to be placed beyond the point of usefulness. Where guaranteed stop orders are not available, not affordable, or not appropriate we need to think of something else.

Money management and prudent position sizing come in here, but they are often thought about in serial terms: a day trader risks no more than 1% of available funds on the “current” trade before moving onto the next one. Any given trade cannot wipe him out.

Traditional investors don’t think in terms of serial trades, but in terms of parallel positions, and so do I. While always retaining some spare firepower for when it is most needed, I’m not afraid of deploying a significant proportion of my available trading funds all at once – so long as I do so in diverse set of positions. This actuarial approach to spreading risk will be familiar to traditional investors, yet it is entirely compatible with spread betting.

Whether you are a regular Joe or a high roller, one thing is paramount. Deploy your deposited cash – however meaningful – across many parallel positions or between several serial trades… and never bet the farm on one throw of the dice!

When Many Baskets are Only One

You might think that you can save yourself a lot of hassle by deploying all of your trading funds into a “diversified” FTSE 100 spread bet on the assumption that you are spreading your eggs across many baskets exactly as in my example above. But you’re not.

When you place a single bet on the FTSE 100 index you are actually putting all of your eggs into just one basket: the FTSE 100 basket. You have to buy the index all in one go, and sell it all in one go, with no ability whatsoever to time the purchases and sales of the individual constituents.

Share Button

Leave a comment