Friday, 5 December 2014

Trading Education- Risk Management


Basic Trading Concepts Defined

Portfolio Diversification

The simplest form of risk management is to follow conventional wisdom and not put all your eggs in the same basket. Or, as the suits say, “diversify your portfolio”. Of course there is a little more technique to it than that (and nowadays we just keep all our eggs in the refrigerator anyway).

Diversity in your portfolio is not about buying different currencies or equities, but evaluating the relative risk of your options and distributing your investments in such a way that you have an acceptable risk-to-profit ratio.

Generally speaking, however, by making several smaller investments, you have less risk than if you make one big investment. This is the principle behind banking. Banks run the risk of their clients not paying them back each time they loan out money. By loaning to lots of people the risk is spread out over all their clients, and it’s easier to compensate for.

For example, say you have an investment opportunity; it really doesn’t matter what it is. For every dollar you put in, you could get back 10; and you can invest in it as many times as you want. But, of course, there’s always risk, and there’s a fifty-fifty chance it won’t work out (which isn’t all that far-fetched; 50% of start-ups go bankrupt in the first year).

So, if you put all your money into it, you could become instantly rich. But, if things go sour, you could lose every penny you’ve got. So, is it worth it? That was a trick question; that’s something a gambler would consider. Traders should be applying risk management instead.


The Key.

The key here is that you can invest as many times as you want (just like with equities markets). If you make one investment, you have 1 chance in 2 of losing (a 50% risk); but if you win, you get 10 times back. This is expressed as profit:risk. In this case you have profit 10 : risk 2, or 5:1 risk-to-profit ratio.

If you split your money in half, and buy twice; statistically speaking, one investment will lose everything and the other will pay off. So if you invest 100: in one you will lose 50, but in the other you will make 500. Net profit? 400. If you had invested all of your money, you could have made 900; but you also could have lost everything.

The important thing to remember here is that by splitting up the investment, you are no longer in an all-or-nothing position (gambling) but in a position where it’s much more likely that you will make at least some profit (investing).

Of course you can reduce some of the risk by using different techniques to try and figure out what will happen, but you can never be certain of the future. Once you’ve minimized as much risk as you can by researching the investment, you can then reduce the investment’s risk by handling how you expose yourself to it.

There are a lot of nuances to improving your profitability by diversifying your portfolio, and these will be covered in more detail in later lessons.

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