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Trading: Managing Risk

July 13, 2008 12:07 PM

womanthinking.jpgTrading is very difficult and I have mentioned before that most of the people that attempt it should not as they do not understand what they are doing. Most people largely guess. Therefore, they cannot possibly manage risk because they do not know when they are likely right and when they are likely wrong. I say likely because trading is probability, not certainty. Nothing is ever certain. I also strongly believe that people should get training before attempting it AND then do plenty of study AND then trade very small amounts until you consistently are profitable. Then and only then, should you even consider trading a lot of money.

With all that said, let’s discuss managing risk. There is always risk in the markets and there is no way to avoid it. But you have to manage your risk the best you can to have any chance of being consistently profitable. 

Let’s go back and look at a stock that I have learned to hate because of it’s volatility - RIMM. It made a fairly strong rejection of the lows on 06/13 with a low of $127.63. What is the trade right THEN on 06/16? Long, IMO. Why? Because traders had a firm number to trade against to be long. Sure enough it skyrockets the next 4 days to reach a high of $148.13. If you had missed that trade on 06/16, do you buy on 06/17 in the $145 range? NOOO. There is FAR too much risk from the low. If you were not already long, you LEAVE IT ALONE.  That is why I said “this stock appears VERY extended here, let it pull back, and look for a reversal somewhere above $135 area.”  Could it have just kept pushing higher and higher? Yes. It could have went to “who knows how high”. I was trying to be subtle that even though we had no rejection of a high, long in that range would have been chasing. Going long there instead of $133 just significantly increased your risk, so why do it?

 On 06/25 it made a low of $137.49, reversed, closed at $142.33 and was ready to propel much higher, and was going pretty much according to plan. This was because you now had two clear points to be long the stock In addition, the stock never made a rejection of a high. Therefore, there were two points to be long and zero points to be short with no firm high. If earnings would not have been right then or earnings were good, the stock was ready to make new highs. In fact, if earnings were weeks away (assuming no news) the probability of it pushing to a new high would have been extremely high. The problem was earnings came out and blew up the chart, but you know my opinion about trading prior to an earnings release - don’t. Pure guessing.  

If you recall, this is the exact same scenario when i said that “the probability we have seen the low on RIMM here is extremely small” and that the only trade was “short below $128.98 and $124.50 unless news” on Thursday and Friday. Why? Because traders had two clear points to be short and zero points to be long. What is “likely” to happen there? It is likely to get hammered. And it did. Without news, the same thing was extremely likely to the upside prior to earnings. It was the exact same setup.

Anyhow, point being, always try and get in the trade early on, never ever chase it. If you were long on 06/16 at the open (as you should have been, IMO) you knew the exit point. It opened at $133.74, therefore your risk was $6.00. Not a small risk, but that is the volatility of this stock. It shot up nearly $9.00 that day and continued higher the following days.

Again, the simple reason to not buy on 06/17  in the $142-$145 range is this. First, the only point of reference to be long was over $15 lower - too much risk. Secondly, each new high there it could reverse and you could have been long into that - not good.  There was no way to know right then if the stock would continue to make new high after new high or not. But if not in the trade near $133 already - leave it alone and either find something else to trade or go play golf. Never chase.

There was only one possible trade after the gap lower that was “sold” and that was short or leave it alone. Period. Do not guess. All of this nonsense from Cramer to “buy RIMM here, it just had a bad day” is pure guessing about where the bottom is. If you “guess” wrong you are toast. And as I have mentioned, never guess. Know where you are likely right and know where you are likely wrong. In addition, you know my thoughts about going long into a gap lower that is sold. It is foolishness, IMO.

It is the only way to minimize risk in the markets, other than NOT having positions going into earnings, which I strongly believe is gambling. Well, that and not trading VERY high beta stocks such as RIMM.

This is how I view the markets and have mentioned that my “take” is most likely far different than most anything you will read or hear anywhere else. Everyone has their own view on when to buy and when to sell, but this is how I personally view the market. Whatever “view” you have, and whatever “indicators” you look at, try and have an idea of when you are likely correct, and when and where you are likely wrong.

Is this how the professionals trade? Probably not. I am not certain exactly what they look at. I would guess their trading methods are far more complex and why Goldman spends over a $1 million training each of their traders. (keep in mind, if you trade, this is who you are trading against, so you better know what you are doing or they WILL take your money) This is simply how I personally view the markets. The point of this article is not to tell anyone how to trade or how to view the markets  on any level as I am not a professional. The point is simply to know when you are likely wrong to manage your risk, however you trade or invest.

Written by Tom@StockBlade.com · Filed Under General Investing/Trading Commentary, Profit Protection - Exit Plan 

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