So last week we talked about how the pros put themselves in the best position to be successful by reducing risk at every possible turn and making it their sole mission to do so.  Did this make sense?  Did this concept occur to you as a newer trader?  It seems so simple but in practice, it can be harder than one can believe. 

There are so many things to think about in trading when you are first learning that sometimes the most important things are lost in the shuffle of learning how to execute the trades whether they be good trades or bad trades.  I want you all to know that this is not just something I have learned on my journey into trading but many of the greatest traders in the world will tell you the same thing… take care of the risk and the profits will take care of themselves.  This was a common theme from Jesse Livermore, arguably the greatest trader of all time.  Some folks will say that when he traded, things were different than today.  We have computers trading and high frequency trading as well.  We have more products and more strategies. 

The reality is that trading today is the same as it was 100 year ago and it will be the same 100 years from now.  Trading will always be about risk and reward.  The great Jesse Livermore was not the only one to believe that reducing risk was paramount to good trading.  If you read any trading books that are worth a damn then you will see that risk aversion is also a common theme.  The Market Wizards all believed and understood that risk is everything.  If you don’t know what I mean when I say Market Wizards, I suggest a quick google of the subject and you will find the greatest collection of traders that possibly have ever lived.  There are entire books just on the subject of risk from the foremost experts in the trading world.  I am pretty sure you can tell by now that I take this subject very seriously and I believe it is in the best interest of every trader to do the same.  Ok, that is my time on the soapbox now let’s get on with a better picture of the scenario that we went through in last weeks blog.

So, we talked about XYZ company having a rough go and a possibility that it was headed to zero.  This week we have such a scenario playing out in the markets.  I am going to use this as a real life example to explain the difference in reducing risk through better trade ideas.  Take a look at the charts that follow to see the risk/reward in each scenario and see which one appeals to you and which one might an experience trader want to get into?

First, we have short stock…

In the short stock trade we have a maximum reward of $1408 and unlimited risk.

Then we have the ATM Put option…

In the ATM put option we have a maximum reward of $1260 and a risk of $135.  I would much rather have a $135 risk than an unlimited risk.  We will put this trade in the “better” category.

And finally, we have the Back Ratio Put Spread…

In this trade we have a maximum reward of $1120 and a maximum risk of just $75.  The $75 represents a reduction in risk of approximately 45%!!!  I know there will be cries that the reward is lower in this trade and those folks are probably struggling with their emotions when it comes to trading because risking $75 to make a $1120 is a stellar trade!!! 

Hopefully you can see from this illustration that reducing the risk is always the way to go and if you need a little more convincing take a look at these numbers.

Short Stock return in % = reward/risk = $1408/ infinite = ?  (We could and would use a stop loss but since we are not stopping out on the other two trades we will stick with infinite risk)

ATM Put return in % = reward/risk = $1260/135 = 933%  (Nice, right?)

Back Ratio return in % = reward/risk = $1120/75 = 1490% (Stellar Trade!!)

Of course this are theoretical returns and would not most likely happen but if the XYZ scenario did play out these returns would come to fruition.  So whenever you are prepping your trades make sure you are asking yourself, can I do better?  

Happy Trading All,

Coach Holmes