Know Your Total Possible Risk

Know Your Total Possible Risk

By Dave McLachlan

With many traders out there calling a start to a new bear market (they’ve actually been calling it for the past 2 months, while the market continues to climb), I thought it might be prudent to show you what we can do in the event that a bear market actually does eventuate.  There is a great way to put all of the opinions of others away and get a good nights sleep – and that is to know your total possible risk.

Your Total Risk: What Does This Mean?

Many of us tend to think that our total risk is the sum of all of our positions, and in a bear market we could lose it all.  Sure this is true if the world ends and all companies go to zero – but let’s be honest: this is not a realistic way of thinking (as entertaining as it is).

No, total risk is actually much less: it is merely the difference between the current stock price and our current stop loss, multiplied by the amount of shares we have for each position we have open.  Let me give you an example:

For simplicity’s sake in our portolio below, we own 3 shares.  Their stats on our trade sheet look like this:

  Current price Amount Of Shares Current Stop Loss Total Risk
Share 1 $12.00 200 $10.50 $300
Share 2 $20.00 100 $18.00 $200
Share 3 $5.00 400 $4.50 $200
Total Risk       $700

 

So while the sum of our holdings is $6,400, our actual risk is only $700 – around 11% of our trading bank.  Yes – there may be some slippage or maybe a price-gap or two, but all in all, if we are risking no more than 2% per trade, these don’t have too big an impact on our portfolio.

If you do the sums on your own portfolio and don’t like what you see (i.e. your total risk is still very large, or more than 20-30% of your portfolio) then maybe now is a good time to lighten a few positions.  Again – this is an individual thing – some people thrive on more risk and others don’t like it at all – but whichever you are, knowing yours is a powerful tool.

The Bear: We Will Usually Get Fair Warning

Believe it or not we were given very fair warning of the crash in 1987 – at least on the chart – and very little slippage actually occurred.  If your stop losses were in, you calmly exited the trade (in most cases still above where you bought in), and then calmly waited for more entry signals to occur down the road.  A simple process.

I urge you to do the sums every once in a while – when the news is blaring and the market is panicking, you will know exactly where you stand and be prepared for the worst.  And as many famous investors once said (I think Peter Lynch, Warren Buffet, and even Donald Trump have been attributed to this):

“Prepare for the downside, and the upside will take care of itself”.

 

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January 4, 2010  Tags:   Posted in: Free Trading Course Lesson Backlog

One Response

  1. Ask Dave | ASX Market Watch - March 29, 2010

    [...] and some (like Macquarie Prime) let you guarantee that stop loss, for a price of course.  Tally up your total risk (where the stock is now minus where your stop loss is, times however many shares you have).  If it [...]

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