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Inherent Yet Somewhat Controllable Risk |
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Inherent in every trade is a certain amount of risk. We can attempt to control our loss by predefining what our acceptable loss will beor what we are willing to risk. Typically we do this by placing a protective stop. In other words, if we're buying 100 shares at $10 each, we can place a stop loss at $9.50, thereby controlling our risk at 50 cents per share. The difficult part of inherent yet controllable risk is that we know how much we want to risk, yet we cannot limit our loss to that amount because of the unavoidable and uncontrollable risk inherent in the trade. |
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A far more insidious unavoidable risk for most traders is the possibility of a series of unprofitable trades taking place. Typically traders lose more equity from this factor than from any other type of risk. Experiencing a series of losing trades is unavoidable; however, with proper money management strategies the losses can be controlledeven if the string of losses cannot be. The dollars at risk are a function of the trading system's probability distribution, which we will discuss shortly. Consequently this type of risk is difficult to ascertain without some fairly advanced math. |
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Unavoidable and Uncontrollable Risk |
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Some risks are impossible to determine or control before the trade is placed. They become obvious only after the trade is entered, and in some cases exited. In other words, you can place a stop at $9.50 so that if the stock drops suddenly, your protective stop will be activated; however, your fill could be considerably less (e.g., $9.00). Once you enter into a trade, your equity is subject to unavoidable and totally uncontrollable risks. Here are the most common. |
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1. Overnight risk. Whenever the market is closed and you are unable to exit your position, you are subjecting your equity to overnight risk. Often the market will open at a different price from where it closed because of bearish or bullish overnight news. If a market opens adversely to your position, the amount of loss you experience will be more than you wanted. In other words, if you are long bonds at 120 12/32, with a protective stop at 119 31/32, and the market opens at 119 20/32, you will be stopped out at a much lower price than you were expecting. |
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In a desire to eliminate overnight risk, some traders only day-trade exiting all positions before the close. The downside is that these traders eliminate favorable gap opens, and increase their transactional costs. (More trading increases the commissions paid and the amount of slippage experienced.) In effect they are substituting overnight risk for sometimes much higher transactional costs. Overnight risk is often followed by liquidity risk |
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