Understanding the Risk You Assume as a Stock Trader
There are two risk factors you, as a trader or investor, can manage when trading or investing in securities. You can control the amount of time you are in the market and the number of shares you are trading.
The long-term investor manages risk by selecting quality issues and holding them for long periods of time hoping to weather the price volatility of the market. The short-term trader manages volatility by limiting the time-horizon of each trade. The longer one is in a trade, the greater the risk.
The larger a position a trader takes-the greater the risk. Therefore, new traders are encouraged to trade 100 or 300-share lots, as opposed to 1000-share lots.
Traders must develop a risk perimeter. They must be ready, willing and aware of the financial and psychological damage the market can wreak on the unprepared.
Each category of trading has its own specific risk characteristics. Each can be utilized with success, or generate losses, for the practitioner. It is the responsibility of the individual to select the trading style that best suits his or her personality.
The following is an overview of some of the risks traders can encounter when investing in the different time-horizons. If you need a further explanation of any of the following material, or if your situation is unique, please feel free to call us.
The Long-term Investor
Long-term investors attempt to overcome the major retracements
the market makes from time to time by holding positions through
these bear markets. Historically, this has been successful. However,
the investor runs the risk of being forced (for whatever reason)
to close positions during the depths of a bear market. Additionally,
the investor must be willing to endure the psychological onslaught
of all the negative news that plunges the market, and the investor's
portfolio, to lows. The longer a position is held, the easier
it becomes for an investor to be lulled into complacency and simply
lose track of the stock. It is also easy to become emotionally
attached to a stock, even when it is losing value.
The longer one holds a position, the more important it is to perform fundamental analytical research. Unfortunately, the investor cannot be sure of being able take advantage of, or avoid, material changes in a company's fundamentals. The company may lose key people, markets, be displaced by competitors, make critical errors or suffer serious financial setbacks.
The Short-term Trader
Short-term traders look for opportunities, most commonly fostered
by unexpected news events, which can be taken advantage of, if
the trader can react quickly. The axiom, "Buy the news, sell the
facts!" describes this mode of operation.
The greatest risk short-term traders face is timing. Can they enter a trade at, or before, the move commences and exit at, or near, the apex? This is never easy. If one enters a trade too late, there is little remaining upside gain. If one is late closing a position, it may have to be sold at a lower price than the original purchase, resulting in a loss. Entering and exiting too soon can be equally frustrating.
The Day Trader
The risk of loss in electronic day trading of securities can be
substantial. You should, therefore, carefully consider your circumstances
and financial resources before you begin to day trade.
The Options Trader
The risk of options trading can be somewhat deceptive. If a trader
is long a put or a call, the individual sometimes thinks of the
risk as limited. In reality, the trader can lose 100% of the premium
paid to buy the option, or the entire investment.
A trader who sells a put or a call may be facing additional risk. A trader who has sold a call has, at least theoretically, unlimited risk. That trader may have to deliver the shares of stock represented by the call to the buyer of the call, no matter how high the stock goes (which is theoretically infinite). The seller of a put must buy the shares of the stock, at the strike price represented by the call, no matter how low the per share price plunges (theoretically to zero).
Therefore the risk is from the strike price to zero.
On various option trades which combine puts and calls (like spreads,
straddles, strangles, etc.), the risk can be calculated in advance
and can range from zero to infinity. The trader must understand
what his or her breakeven and maximum risk price points are in
advance.
In conclusion
Understanding the risks of trading, from long-term investments
to brief momentum trades, is critical for anyone interested in
the stock market.
MarketWise.com supports traders of varying time-horizons. We can help you make your decision regarding which trading style is right for you, but we cannot make the decision for you. Please call us if we can be of any help. |
