However, a decline in the price of a stock can hurt the stock trader’s portfolio. This is referred to as downside risk. When you are long a stock, the downside risk is limited to the price that the stock is. This means that if Trader A purchased 100 shares of XYZ for $100 per share, his directional downside risk is limited to $100. If Trader B also purchased 100 shares of XYZ, but for $50, his directional downside risk is limited to just $50.
What about futures traders? Long and short futures traders have directional risk, but because futures trading is a zero sum game, both long and short traders have equal directional risk -- both upside for short sellers and downside for buyers. Let’s get back to our stock traders above. Which has more directional risk, Trader A or Trader B? Trader B has 1/2 the directional risk when compared to trader A. Is there any way Trader B can have the same risk as Trader A even though both traders bought at different price levels? Yes he can. Here’s how:
- Portfolio Risk is determined by taking the number of trades in one account and analyzing the total risk of the entire portfolio. Trader B can have the same risk above as Trader A if he/she were to buy 200 shares of XYZ at $50. Many traders think that buying more shares at cheaper prices lowers their risk while increasing their rewards. This is all too common in the marketplace. The trader who puts too much money on one trade can open himself up to a greater drawdown. It pays to not only research your trades, but to diversify your account, not only in different trades, but different sectors as well. While we may have a long bias in the Bond market, we may elect not to take a long biased trade in the T-Notes due to too much directional exposure in debt instruments that correlate together.
- Volatility Risk can be described by how much or little an asset or derivative that is being traded moves. It makes no sense to trade in a volatile market that could risk a margin call and wipe you out of a potentially good trade. The margin requirements are there for a reason. If the historical volatility on an asset or derivative were to double, so could the margin to trade it. This helps take the risk out of the brokerage firms’ hands and puts it into your hands. Volatility risk for an options trader is different however, according to his/her trade. If the trader is long volatility, any trade that dramatically rises or falls is good for the trader. Traders who are short volatility are looking for a collapse in volatility, or dull market conditions. In each case, the volatility traders are looking to gain by market momentum, or lack of it. Any trader short volatility in a market collapse could certainly lose his entire portfolio. What about the long volatility trader? Where does his/her risk come from?
- Theta risk is for long options traders only. Theta risk is how much option’s premium is lost while holding a long position. Option sellers do not have theta risk, but they have volatility risk. As for the option buyers, the theta risk is determined by how much or how little was paid for the option they hold. Obviously, the less paid for the option, the less theta risk is involved.
We are continually teaching our students how to limit risk while still being able to realize a good reward. We concentrate on strategies that are not only non-directional, or have a directional bias, but other things as well. We try to develop strategies that are not only delta neutral, but theta and vega neutral as well. This type of strategy can consistently crank out good yields while limiting your exposure.
We try to develop strategies that are not only delta neutral, but theta and vega neutral as well. This type of strategy can consistently crank out good yields while limiting your exposure.
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