Hello Tackle Traders! We have been talking systems the last couple of weeks and we are going to continue down this road as promised in the last go-round of this blog. I feel this is important because I am currently reflecting on my own trading journey and I am trying to think of all the things I wish I knew when I started trading that I know now to be absolute facts! The reason I am going hard on this risk concept is that it is the one thing that can make or break a trading career.

There are some other reasons that I want to discuss risk and I want to share with you a personal story of risk that fortunately turned out well for me but that also sheds light on how at the moment it may not be easy to recognize the risk we face but upon later reflection, it can dawn on one that the risk might have been a lot higher than expected.

This is my story and I do not recommend trying this at home. LOL If you have ever been to Jamaica, more specifically Negril, Jamaica, there is a place called Ricks Cafe. It is less of a cafe and more of a bar but that’s not as important as the other features of the place known as Ricks Cafe. You see Ricks is set upon a cliff and has some of the most fantastic views of any place I have ever seen. At the bottom of this cliff is a turquoise pool that is absolutely breathtaking. Now, there has always been talking or more appropriately red-stripe beer-fueled banter as to how high the top of this cliff is down to the water down below? I don’t really know how high it is but I have seen estimates of anywhere from 25 to 40 feet above the water.

It’s kinda funny when one is standing up there getting ready to jump off or even dive off the cliff that it seems more like a thousand feet high but I am sure that is just perception and not reality. So by now, I am sure you are picturing this in your mind and asking yourself what the heck does this have to do with trading and more importantly risk? Well, I am very glad you asked, well you didn’t ask but I’m going to tell you anyway. This is where the risk part of the story comes in. I was at Ricks Cafe with a couple of friends of mine and we were debating on whether it was a good idea to jump off the cliff into the water below. As it turns out we determined it was worth the risk to jump off the cliff into the water below, at the time this seemed like a perfectly good idea. We had seen others jump-off with no ill effects and it seemed like a lot of fun. So after some more talk and more beer my one buddy jumped off into the water below and was thrilled. He then swam back into the cave and climbed up what some would call makeshift stairs back up to the top. With myself and my other friend standing there admiring the feat just performed by our buddy, he started in with the “what’s the matter with you chickens?” talk. Now, I will say that he did not use those exact words but I am trying to keep this blog somewhat PC. After a few minutes of this hazing, my other buddy jumped off the cliff and also enjoyed it immensely. After he came back up to the top then it was my turn and since we had been friends for a while and always had a reasonably healthy attitude towards friendly competition the hazing escalated as it usually does. So as any red-blooded twenty-something male would be prone to do when challenged by his friends I had to say to my pals, “hold my beer and watch this!” I then proceeded to DIVE headfirst off the same cliff that my buddies had just jumped off of. I headed down toward the water at what can only be described as Ferrari like speed and plunged into the water. Now some of you may be saying, no big deal and some of you may be saying this guy is all kinds of crazy and both camps are probably right but here is where the risk increases. To that point in my life, I had only dove off diving boards into pools that were at best 3 feet from the water level and I had exactly zero formal training in diving technique so god only knows how it looked to see a 6foot tall, 250-pound man falling down towards that water! Anyway to make a long story, less long I made the dive and I lived to tell the tale. At the time it seemed like no big deal but as I look at it now after time has passed and life experience has grown I look at all the things that could have went wrong and think that maybe it wasn’t the smartest thing I have ever done. Here is a picture of Ricks Cafe for perspective.

This story above relates to trading and risk in the same way as I now view this situation. There was a tonne of risk involved with this event, I could have broken bones, or much worse. I got away with it when I did it but what I had done this a number of times? Perhaps, I had attempted this 10 times in a row? What happens if my entry in the water was not good or maybe I touched the bottom? You see the risk here was all the things I just mentioned and the reward was a bit of fun and a good story. I relate this to the high probability trading that we have been talking about for the last few weeks. We used the card example last week to visualize the perils of a high probability system but now I am going to use an actual trading example to illustrate the point and hopefully, you can see the parallels between the risk in my story and the risk in the system I am about to describe.

There are some popular trading systems out there that use OTM credit spreads to collect cash flow. These systems can be great because the win ratio is very high. Let’s take a .20 delta short leg credit spread. For example, let’s say we believe AAPL is going to stay above a certain level and we want to give ourselves a huge headstart on the trade. Here is the entry for the trade and the risk graph as well.

As you can see from the trade above we have an approximately 80% chance of being right on this trade, however, if we look at the risk vs reward then you can see how something like this might go very wrong much like my dive off a cliff. You see the reward is $84 but the risk is $322. Much like my cliff dive, you may get away with these high probability trades for a while or you may run into a string of losers the first time you try one of these trades. You see this is what we don’t know when the losers and winners are coming through and therefore we must be careful.

For the last few weeks, we have been talking about risk with these types of systems because it would only take a couple of losing trades like the one above before you could dust an account. Even though we have a high probability of winning it doesn’t mean its foolproof. We need to make sure we understand the risks before we get involved, unlike the performance I had in Jamaica. One of the biggest problems I see is not knowing all the risks and more importantly knowing how to deal with the risks.

We have given a couple of examples of the traps that can be found with systems and over the next series of blogs we will see what parts of the system we can focus on to prevent the disaster that can befall anyone in the trading realm. I would encourage anyone reading this blog to really go through their current systems to see if there are any pitfalls that they may not have planned for and thinking about how to guard against them.

Until next time, trade well!

Coach Holmes