“Managing risk” is a phrase that is often tossed about as an important aspect of trading… but do you really know what it is?
As many of you know, I was actually a rocket scientist. When I worked on the initial phases of the Delta IV program, we had an entire Risk Management department tasked with defining, calculating and managing the risk for the new rocket. It was a very serious and formalized process that gave me a solid foundation in risk management. So what exactly is risk management as it applies to trading?
Let’s start with a little bit of history. The word “risk” comes from the Italian “risco” meaning danger and “rischiare” “to run into danger”. Risk as a science has been around since the sixteenth-century Renaissance, largely stemming from the precursor of trading – games of chance.
Attempting to analyze these games of chance led to the discovery of the mathematical theory of probability. (Yes, people have been trying to find an edge for centuries now.) Two mathematicians, in particular, Blaise Pascal and Daniel Bernoulli, were instrumental in defining risk. Some notable examples of their relevant work include Pascal’s triangle, which determines the probability of possible outcomes. (That sounds a lot like the first step in managing risk, doesn’t it?) Pascal’s Wager shows a decision matrix of decisions made with uncertainty. And in 1738, David Bernoulli published a paper titled “Exposition of a New Theory on the Measurement of Risk” in which he introduced the concept of utility, a measure of the consequences of an outcome in evaluating risk.
Now let’s move on to some basic definitions. Probability is the likelihood that something will happen. A Consequence is the result of an action – in risk management, we generally mean the effect of an unsatisfactory outcome. Acceptable Risk means that we can live with the worst-case outcome.
There are two major activities involved in the risk management process. The first activity is risk assessment, the action of defining the risk. The second activity, risk control, resolves the risk. Risk control is the process of developing risk resolution plans, monitoring risk status, implementing the risk resolution plans and correcting for deviations from the plan.
The basic concepts of risk management are:
- Goal – We manage risk in relation to a specific goal and can affect only that part of the trade that remains open to achieve the goal. What is the risk in the plan? What is the risk in the remaining trade? A clearly defined goal with measurable success criteria bounds acceptable risk.
- Loss – There is only risk if there is a potential for loss. That loss may be monetary or a missed opportunity (aka opportunity cost).
- Uncertainty – Uncertainty comprises those things that we don’t know. It’s fairly easy to identify many of the uncertainties we face as traders, with price movement having the most impact. (Though as I’ve previously mentioned, the impact of life can be even more devastating on a trade – writes the person who had to trade while in the midst of food poisoning.) We do know that the probability of risk occurrence is greater than zero percent and less than 100 percent. This means that we don’t know if the risk will (100%) or will not (0%) occur. The likelihood that a loss will occur helps to determine the relative priority of the risk.
- Time – As time goes by in our trades, viable choices decrease. (As an example, in expiration week, there won’t be significant amounts of time premium far away from the money.)
- Choice – Without choice, there’s no risk management. Sometimes we believe we can’t control risk or don’t know how to select from the available choices. (Anyone who has tried to figure out the BEST adjustment will understand the importance of this one.) Doing something or doing nothing should always be a conscious decision. Understanding the goal and the risk of not achieving the goal helps to decide the right choice.
So what’s the point of risk management?
- Make intelligent decisions. First and foremost, we want to make good decisions based upon our understanding of the risks inherent in our trade.
- Resolve risk. We create and use a trading plan largely to resolve risk. The key to resolving risk, however, is finding it while there is still time to take action, as well as knowing when to accept a particular risk. It is possible that your risk resolution strategy is not to minimize risk (more of an M3 type of trade) but rather to maximize opportunity (more of an M21 type of trade). Acceptable risk is defined by the trader.
- Prevent problems. Risk resolution prevents problems and surprises. Risk management is a proactive strategy to reduce the likelihood of major losses.
The key is to realize that it is quite normal to start the risk management process with fuzzy issues, doubts, concerns, and unknowns. The process of risk management transforms this uncertainty into acceptable risk.
Still interested? Stay tuned…
Written and contributed by Cynthia Sarver, Successful Options Trader of the Month – February 2016