Risk Management and Risk Types: How They Impact Your Trading – Lumber Liquidators (LL) | United States Oil (USO)
As traders, we are exposed to the wild ups and downs in the market everyday. We are often present for every tick, every piece of breaking news, and every rumor from all corners of the world that cause extreme market fluctuations. Oftentimes, that is how we make our living, those very market fluctuations caused by seemingly obscure and questionably relevant information. It is that information that drives the underlying emotional and psychological swings in the market. There are many principles at work in the markets; fear and greed, and supply and demand are among the most prominent and well known. In reality, these principles drive much of the day-to-day activities, but it’s important to understand that they aren’t the only forces at work. Governments, wars, political tensions, global economic policy, macro and micro economic principles are all contributing factors to what make the stocks we trade go up and down.
Thrre are many different types of “trading” and investing. Regardless of your persuasion, everyone shares one common denominator when exposed to the markets….risk. Day and swing trading happen to be the most common forms of exposure I deal with. When I am teaching new and experienced traders how to trade different strategies or find trading and investing opportunities, one common theme I always reiterate is with regard to risk. We will focus on the impacts of risk in each of these situations. To be a self sufficient, profitable trader, you must learn to master your risk. But, before you can master your risk, you must understand risk and how it impacts our markets, individual stocks and your psychological abilities to manage your positions as a trader.
So, what is risk management and why does it matter? Risk management is really a two-step process where an investor or trader determines their risk exposure in a particular investment. Once we have determined our exposure, the second step is determining the appropriate technique to apply for mitigating that risk as best we can. Hands down, as a trader and investor, risk management is the most important factor to consider when trying to make money in the stock market.
Some of the most basic ways to mitigate risk in the markets are probably some of the oldest methods you might have heard of. Things like never using more than 10-15% of your portfolio in any single investment. By avoiding over allocating your portfolio, you protect yourself from having too many eggs in one basket. Setting stop losses and defining profit targets is another big one. Nobody wants to be long in a trade that goes to zero, so, have your exit in mind. Have a maximum loss that you can stomach…and stick to it! Another easy way to protect your portfolio long term is to determine if a trade has a risk reward ratio that is GREATER than 1:1. If you are risking ‘1’ on every trade, strive to find trades that provide AT LEAST ‘1’ if not ‘2’ as the reward. Don’t buy tops, don’t chase runners, and don’t hold your losers. If you don’t understand what a risk/reward profile is or how one works, you should be taking notes and ferociously searching that term on the internet.
The most common and well-known risk type that we deal with as traders is market risk. Market risk is also known as systematic risk. This is what we all face, everyday as day traders, swing traders and investors. If you are day trading, you can often capitalize intraday on the volatility that surfaces from systematic risk. As swing traders, we are exposed for a longer period of time. Systematic risk occurs when we are subject to realizing losses from factors that affect the overall market performance. This can be from war, hackers attacking the exchanges, rumors about terrorist attacks, and macroeconomic news from other countries that impact our own financial markets. Basically, it is the one type of risk you cannot avoid or ignore when trading or investing. It is inevitable that at some point in your trading career, you will have a face-to-face experience with systematic risk. And, you will know when it happens.
Another common risk type we see is operational risk, or business risk. This is the risk of loss an investor faces that is directly related to the industry or a company itself. Examples include: earnings and guidance, SEC investigations, CEO’s getting fired, employee strikes, analyst downgrades and new debt announcements, etc. Business risk is often referred to as unsystematic risk. This is the kind of risk where everything is fine one day, and the market is soaring the next, but your favorite stock to trade has gone against you. You check the press releases and news out for your ticker, and find out that they released some bad news about something late Friday night, after the markets had closed. Yes, that actually does happen. When companies want to hide their dirty laundry or minimize the impact of the bad news, they often release this news when people are less likely to be paying attention.
Legislative and/or legal risk is one of my favorites. This is the risk to investors that occurs when a company fails to get FDA approval for a drug. When state legislatures ban or allow the recreational use of marijuana, the pot stocks are going to experience this risk type. Additionally, unexpected industry regulations set forth by the SEC or the government can also impact the ways companies do business, therefore affecting their stock prices and market value.
A good example of several of these risk types can be found in the recent Lumber Liquidators (LL) fiasco.
First they were hit with a myriad of business and operational risk from internal quality control issues to rumors about their products knowingly being shipped with hazardous chemicals. Next came legal risk in the form of US Senators calling for a federal probe into the company. Follow that up with news of activist investors taking a massive short position in the company, betting on it to fail. And most recently, legal risk has resurfaced once again in the form of a class action lawsuit. In all, after only 9 market days of risk exposure, this company has been crippled and brought to its knees. Lumber Liquidators (LL) has literally lost nearly 60% of its market value in less than two full trading weeks. If that doesn’t open your eyes up to the importance of understanding risk, and learning how to manage risk, then I can’t help you.
While the Lumber Liquidators (LL) example was on the extreme side, it is very relevant. Moves like that are happening all around the market everyday. Some present unique buying opportunities, some bankrupt the fortunes people have invested and some are for the greater good of the consumers and overall market.
A different example, that is nearly as extreme as Lumber Liquidators, can be found in my most recent United States Oil (USO) position trade. I began accumulating shares of USO back in December 2014. As you are all undoubtedly aware, Crude Oil has taken a major hit in the past half year. It is also trading about 60% below the highs. However, oil is trading lower for a much more different reason than litigation and quality control issues. USO is an exchange traded fun (ETF) that tracks Crude Oil futures. Crude Oil has been trading fundamentally for quite a while now. This means it is moving on more fundamental catalysts rather than technical chart setups. Oil is much more subject to the laws of supply and demand than your traditional stock. As such, when a global commodity such as oil is affected by risk, it is almost always systematic risk…market risk. Trying to call a top or bottom on a sector, stock or market is very difficult to do. But, you can trade ahead of reversals if you know how to do it. I was managing my risk in USO by buying puts to the downside as the stock kept dropping along with Crude Oil. When it would pop up, I would sell out of the money covered calls into the spike. Once I accumulated my full position, I didn’t need to buy more shares to average down, or to hedge my long stake. I used options. This gave me the opportunity to stay in the trade long enough for it to be profitable and avoid having to bury my account in one position. I outlined the details of this two month long trade, including my risk management techniques in a blog post I did a few weeks back, “The Good, The Bad, And The Trade From Hell That Paid Me $5400 In Lunch Money.”
As I stated before, there are different risk types and equally as many ways to manage your own risk in trades. It doesn’t really matter how from person to person, so long as you make an attempt to protect your hard earned money from potentially disastrous consequences that are prevalent in any market.
Common methods for managing risk in trades can be in the form of protective puts using options, something as simple as finding a stop loss area on a chart based on previous support and resistance levels. Scaling into trades with half size until the trade is moving in your favor, giving yourself room to ride the trend a little longer. Selling covered calls to lower your net cost in a trade is a common way to manage your risk. I have done all of the above, and various combinations of these ideas. Each trade has to be evaluated on a case-by-case basis. You have to have a plan for each trade and understanding of the risk associated with it. That is the most important part of your trading longevity. In my Swing Trading Education Course, I spend a huge portion of time talking about risk management techniques and how to apply them in all sorts of trading conditions. Expect to lose and accept those losses. Learn to be a self sufficient, master of risk.
If you have any questions or comments, don’t hesitate to contact me: [email protected]