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Chapter 8: RISK CONTROL

The traders who win are those who minimize risk. This is another key chapter and its importance is such that readers should read it carefully and ensure they understand its contents. Those who do not minimize risk inevitably pay the price and get wiped out.

It is for this reason that you often see strong moves after a news item is out of the way, often a news item suggesting a strong move in the opposite direction. The big traders, who got that way by minimizing risk in the first place, wait until the risk is at its lowest, when the news is out of the way.

Risk Control includes the following:

1 Not trading in too big a size, thus reducing the risk of a wipe out. Actually you should eliminate the risk of a wipe out .

2 Not holding overnight unless you have a profit buffer in place. However this does not apply to particular methodologies seeking to take advantage of certain factors which may apply to holding overnight.

3 Not holding over the weekend, subject to the same caveats as “2” above.

4 Taking appropriate action prior to major new items. This means not normally opening positions, maybe reducing position size if already positioned – although it does depend on your trading objectives.

But in markets there are two types of risk and we need to look at both. First there is the risk of loss inherent in the market itself. Second there is the risk of loss inherent in the vehicle we are trading. I deal with this in more detail later on (see Chapter 10), but simply put, the risk of making a losing trade when buying an option is far higher than when writing an option. But you can lose a lot more writing options, than you can buying them. This neatly demonstrates the two types of risk and, as traders, we need to understand how this works.

Risk inherent in the vehicle

First we will look at the risk inherent in the vehicle. This is really part of knowing your vehicles well and, as such, is part of the initial learning curve. If we take the example of buying a call option for 25 points. Our maximum loss is 25 points, we simply cannot lose more than that. So whatever happens we are safe, as long as that 25 points fits within our Money Management system. IBM, ICI, Microsoft and JP Morgan could all go bust and it would not make any difference. This is a very different situation to that in place if we had decided to go long either by writing put options, or by buying futures. In both those cases we would have lost point for point with the index futures (or whatever it was we were trading). Clearly a very different kettle of fish!

This gives rise to a useful point. As traders we want to keep as many options open as possible (I don’t mean market options in this context). In certain situations one trading vehicle may offer a better deal. For example a cheap option may make sense if we want to trade ahead of a news item. A pair of cheap options (i.e. a put and a call) may make sense if we expect a big move but do not know in which direction – I adopted this strategy the Friday before the 1987 Crash on the OEX Options. A deep-in-the-money option may make more sense than trading the futures on occasion. This is because first, it may cheaper, and second, it might put on time value as the intrinsic value reduced. So it might give you more on the upside, at a lower risk on the downside. All of these can be very useful in trading markets and it is critically important that a trader is fully aware of the risk profile of the vehicle traded. This is simply because this impacts on the risk profile offered by the market itself.

Risk inherent in the market

This brings us back to the risk inherent in the market itself. My experience is that when we start to trade, we trade in blissful ignorance of this risk – what some would call a fool’s paradise. We then get a good kicking and become fearful. Yes, we are back to the Traders’ Evolution as set out in Chapter 2. Finally we become “Risk Orientated.” That is our goal. So risk goes to the heart of the trading experience. It is learning to live with risk that defines the trading experience. It is our stock in trade, even more than money. Money is the result once we learn to control risk. To an extent this whole book is about risk control. That is what Money Management does, that is what the three simple rules do, that is what our entire trading system does, and discipline allows us to control risk by using these other tools correctly. However, this section is about avoiding the more obviously high levels of risk which the market regularly encounters, mainly in the form of expected news items.

Other forms of risk

But there are also many other unexpected forms of risk. Even when a news item is expected its content can come as a big surprise. In my experience most market shocks come in whilst the market is open, but that is not always the case. Often markets do see sharp action into the open as they are forced to digest some event that has occurred whilst they have been closed. The trend towards 24-hour markets, evidenced by Globex, can be useful in this respect but, as traders, we cannot be awake 24 hours a day; we have to sleep. Also these markets are not ideal; they tend to be traded rather thinly and thus exaggerate any move that comes their way. Often the level of the S&P futures on Globex is not representative of what the official S&P futures do when they open for real. But even with Globex, once the news is out you are not going to get the right price. But that is not the point. I see no reason to trade off news items, it is rare that the news really has any effect. At least any lasting effect. Many will recoil from this statement in disbelief. But the fact is that “markets move from extreme to extreme across all time frames,” good or bad news becomes irrelevant within that context. The market will just keep rolling until it has reached the next extreme. What marks the major extremes are two key, but linked factors. First is the extreme psychology, “you must own stocks” (which we have in the late 1990s) as opposed to the converse philosophy, “stocks are far too risky” (which was all pervasive in the mid-1970s). These extreme statements define the psychology and define the peaks and troughs. The one being seen now drags everyone into the market. When everyone is in, there is no one left to buy and so the market will go down. It is very difficult to time such extremes, but there is no doubt that a large fall is coming, it may have started. Similarly the statement, “stocks are far too risky” defines an extreme low, no one wanted to own stocks, hence it could only go up.

In this context the market is very much like a mechanical device. Having gone one way and reached that extreme, it has no choice but to go the other way.

However, when trading derivatives we cannot key into these very large moves and have to have regard to the shorter term action. Indeed it can be a mistake to ignore any extreme, however small the time frame, because everything has to start somewhere.

To get back to news items. For my own trading purposes I use them to enter the way I wanted to in the first place. What I like to see is when the market reacts positively to “bad” news or negatively to “good” news. Not that I really believe in such classifications. There is no such thing as good or bad news, it all depends on your perceptions and what comes next. Often very good events follow “bad” news, and very bad things happen as a result of “good” news (see Chapter 25).

So traders should use the news to suit themselves. Don’t view it as a negative, merely adjust position size (maybe to nil) ahead of the news and then use the prices generated subsequently to your advantage.

I believe there is less risk holding overnight or over a weekend than there is holding into a news item. But the longer the time when the market is closed, the more that can happen, so this also must be considered.

SUMMARY

 You must minimize risk if you are going to win.

 There are two types of risk in the market:

1. There is the risk inherent in your trading vehicles.

2. There is the risk inherent in the market itself.

 The market mechanism drives price from one extreme to the other. Once an extreme is reached price can only go one way.

 Good news and bad news represent risk, but the market can provide excellent indications that an extreme may have been seen.