Introduction to Risk

An Introduction to Risk

What is risk? Unfortunately, the dictionary definition — “the possibility of bringing about misfortune or loss” — is incomplete. Let’s define risk as the extent to which a trade might vary from an expected return. I’ve purposely defined risk this way because, as we evolve into experienced traders, there may be several different expected trading outcomes, each with its own associated risk.

 

All investors, and most beginning traders, focus on downside risk. They think of risk as an unexpected loss of value in a stock or an investment portfolio. And they’re right. But for our purposes, this view is limited and counterproductive. As active traders, we are aware that many separate and individual forces are at work that, if understood and properly managed, can actually enable us to make money while others lose it. By learning to accept and work with these forces, we have more influence over our outcomes than those who accept the seemingly random outcomes of the market.

 

A basic idea in trading is the relationship between return and risk. The greater the potential reward, in general, the greater the risk assumed. Our markets reflect this principle in the pricing of stocks and bonds. Strong demand for safer investment vehicles drives the price higher and the return lower. Weak demand does the opposite.

 

For example, U.S. Treasury Bonds are considered one of the safest investments because the likelihood of default is extremely small — although certainly not zero. Because a corporate bond is more likely to go bankrupt than the U.S. government, investors require a greater return on these investments because there is a higher risk.

 

The most widely used measure of risk in the financial markets is variance. This is a measure of the probability distribution that the actual return we experience over many trials will equal the expected return we predicted. If we are uncertain about our prediction, the larger the range of possible returns and, therefore, the more uncertainty there will be in our actual return — and by our definition, the greater the risk.

 

Let’s examine how we can quantify risk so we can compare one trade with another.

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