The second principal component of a trading strategy is the management of trading risk. Many isolate and identify many different forms of risk. To some extent, these different categorizations of risk can prove helpful when designing ways to manage them.
The New Oxford American Dictionary defines that aspect of risk of interest to us as “The possibility of financial loss.” Trading risk is defined as “The possibility of financial loss from the activity of trading or investing.”
This does sum it up rather well.No matter how many ways one chooses to view, define, and label risk, it is central to the understanding of trading risk to know that it is result of exposure to loss from any open trading position. Put more simply, if you have a position in a market, you are at
risk of losing money. Of course, you can make money in trading only by taking positions in the market.
One might say that this is the central dilemma of trading. To profit from trading, we must incur risk. As they say, “Nothing ventured, nothing gained.” However, and this is the bottom line, without the successful management of risk, there will come a day when we will no longer be able to
trade because of the cataclysmic trading losses that have come from our unmanaged risk.
The essence of good risk management is to risk as little trading capital as necessary so as to maximize profit. This is easy to say. Doing this well, however, is one of the most difficult aspects of trading strategy design.
Risk can be broken down into three broad categories: trade risk, strat- egy risk, and portfolio risk.
The definition of trade risk is: “The possibility of financial loss from an individual market position.”
The definition of strategy risk is: “The possibility of financial loss from the use of a trading strategy.”
The definition of portfolio risk is: “The possibility of financial loss at the portfolio level (potentially multistrategy, multiple time frame and mul- timarket) from the sum total of all trading therein.”
Let us examine each of these forms of risk in more detail. |
The managemet of the risk
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