Thursday, April 09, 2009

Understanding All the Risks in a Trade

Trading Risk

Typically, I teach people to think about two kinds of risk in a trade: the risk in your stop and position sizing risk (or the total risk to your portfolio). However, there are many other types of risk in a trade, especially in these market circumstances. I thought this would be a good time to detail all of them.

My complete list of risk types:

• Predetermined risk in a trade (1R)

• Position sizing risk (the total risk determined by R and your position size)

• Market risk

• Group risk

• Instrument risk

• Underwriter risk

• Currency risk 1 (inflation/deflation)

• Currency risk 2 (a decrease in the value of the underlying currency)

• Government risk

• Psychology risk

I had no idea that there were so many different kinds of risk in a trade until we entered into this market climate. Let’s review each of them.

1) Predetermined Risk (1R). I have said for many years that you should not enter into a trade without knowing when you are wrong about the trade and having a stop order in at that point. For example, a good substitute for buy and hold in the stock market is the 25% trailing stop. Your initial risk should be 25% of the entry price. You are wrong about the trade if it drops below that price and should get out. This is a typical example of what I’ve called 1R throughout my teachings. With a trailing stop, every time the stock makes a higher close you should raise your stop so that a 25% drop from the current level gets you out.

2) Position Sizing Risk. It’s your total risk when you multiply 1R times the number of shares that you purchase. For most of you that should equal about 1% of your portfolio.

3) Market Risk. All ships go up or down with the tide. If the whole market goes down, most stocks go down with it. However, this sort of risk is well-controlled by position sizing.

4) Group Risk. This is risk in the group of stocks or commodities that you are investing in. For example, precious metals stocks tend to move as a group. Financial stocks tend to move as a group. However, this sort of risk is also controlled by your position sizing.

5) Instrument Risk. I hadn’t thought much about this type of risk until I wrote about the GLD ETF. You can find my article on the topic in a previous newsletter. When you invest in the GLD ETF you think you are investing in GLD, but you have no real idea whether or not GLD owns the gold you are investing in. There are no guarantees. Thus, gold could continue to go up, but suddenly GLD could plummet simply because something happens to show there is no gold to back up the investment. You should always ask yourself, “What is the safety of my underlying instrument?”

6) Underwriter Risk. What happens if you own GLD and HBSC (the bank that is supposed to have the gold) fails? HBSC has numerous custodians and subcustodians that theoretically have the gold behind GLD in their vaults. What if one of those banks fails? And that’s just the bank behind GLD. What if the company that underwrites a whole group of ETFs (i.e., Lehrman Brothers) fails? What if the company behind your mutual fund fails? What if your hedge fund fails? Or what if one of those companies turns out to be running a ponzi scheme? These various forms of underwriter risk are VERY REAL in today’s market climate. Thus, you should ask yourself, “What could possibly fail, making this investment worthless or tied up in the courts for some time?”

7) Currency Risk 1 (Inflation/Deflation). The current secular bull market started in 2000. Bear markets can be inflationary and deflationary. In an inflationary market you might find that the government could depreciate the value of your currency by 90%. Right now the S&P 500 is at 768. Suppose we started a good rally that took the S&P 500 to 3072—that’s 400%.

But what if the currency was inflated so that the dollar was only worth 10 cents by today’s terms? That would mean that the S&P 500 at 3072 was only worth about 307 in terms of today’s dollar. You would have really lost about 60% of your money. This is very real because the government manipulates the inflation data to make it seem much lower than it is and the only real solution out of the massive debt of the U.S. government is to inflate it out of existence. Notice the Zimbabwe note below. It’s actually a real note for $100 trillion Zimbabwe dollars. If the U.S. dollar did that, then our $100 trillion debt would be almost gone. I believe that this is the largest note every printed in history. I have a $500 billion Iraqi note, but this one is 200 times bigger.

By the way, I bought one of these on eBay for $18. At the end of March they were selling for $8 each and a 100 pack for $299. The currency no longer exists and it is still going down in value. Always keep your eye of the inflation/deflation potential of the currency in which you are investing.

8) Currency Risk 2 (Relative Value). Let’s revisit our example of the secular bear market starting in 2000. The first downleg ended in 2002, and then in 2003 the S&P 500 went up about 30%. However, that downleg corresponded with a huge decline in the US dollar. It lost about 40% relative to the Euro in 2003. While Americans thought they had made money, most of them hadn’t relative to the Euro and most other major currencies. This brings up another thing to monitor: “How well is my currency doing relative to other currencies?”

9) Government Risk. Do you trust your government? The government can make its own rules and change the value of your investment in a heartbeat. For example, when the Hunt brothers tried to corner the silver market, the government decided to stop them. First, margin rates were raised. That didn’t stop them. The rates were raised again, but that still didn’t stop them. And then the government did something that I, to this day, can’t believe. They decided that you could not buy silver anymore—you could only sell it. And since there were no buyers for the seller, silver dropped like a rock. The government has also confiscated gold coins, refused to honor its pledge to back our currency by gold, and told the U.S. states that income taxes would only apply to the very wealthiest of Americans and would not exceed a top rate of 6%. You should always be looking at what the government might do to ruin your investment.

10) Psychological Risk. This is probably the biggest risk of all because you are the biggest risk to your investments. The average trader is probably about 90% efficient, meaning they make a mistake in one out of ten trades, where a mistake means not following a sound trading system with written rules. This is probably the biggest risk you face at any time with your investments. And if you don’t have written rules to guide you, well, that just illustrates my point—everything you are doing is a mistake.

Typically, people enter into a trade oblivious to the number of potential risks they are taking. However, if you study and understand these risks, then you can minimize them.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Dr Van Tharp at International Institute of Trading Mastery.