Some thoughts on Risk Management

Most traders and investors don’t think about risk and that is why they aren’t successful. When you take a position or enter a trade, you shouldn’t just be thinking about how much you can make. You should also be thinking about how much you can lose.

When most professional investors manage a portfolio they balance it by weighting all of the positions at the same size.  For example, if they have $100,000 and they invest in ten positions they will put $10,000 into each one so each position has a 10% initial weighting in the portfolio.

There is a better way to do this and that is instead of balancing the portfolio by using position size, equate the positions by using the size of the risk. The mathematics behind this can get very complicated and some funds literally have rocket scientists working for them doing the calculations, but the concept is simple and if you start thinking in these terms it will help your performance.

Think about the risk.  A way to do this in this example would be to set a maximum loss in each position of say $1,000.  This would be accomplished by using stop-out targets.  For instance, if you buy 1,000 shares of a $10 stock and then set your stop-out at $9.  That’s where you would sell it if it goes down so you would take a maximum loss of $1,000.

If you balance your portfolio by risk, the positions will have different weightings.  For example, if you invest in an option contract that in a worst case scenario could expire worthless causing you to lose all of your money then a $1,000 investment in that one contract has the same risk exposure as the $10,000 investment in the stock that was just mentioned.

It would also equate to a buying 2,000 shares of a $20 stock and having the stop-out at $19.50. This could be the case if the $20 stock is less volatile than the $10 stock so you would have a tighter stop-out level. Once again the maximum loss you could take is $1,000.

So these three positions have equal risk exposure-

  1. 40% of the portfolio or $40,000 in 2,000 shares of a stock that is trading at $20.  The stop-out is at $19.50 so the maximum loss is $1,000.
  2. 10% of the portfolio or $10,000 in 1,000 shares of a stock that is trading at $10.  The stop-out is at $9 so the maximum loss is $1,000.
  3. 1% of the portfolio or $1,000 in one option contract.  This could expire worthless so the maximum loss is $1,000.


If you think this way, you will put less money into your investments that have greater risk.  If you are just balancing the portfolio by weightings, this won’t happen. A $10,000 investment in an option position that could expire worthless and cause you to lose all of your money has a lot more risk investment than a $10,000 investment in a blue chip stock that isn’t very volatile.

Of course these are very basic examples and like I said the math here can get very complicated, but it is an easy concept to understand and it will help your trading. Think about balancing your positions by equating the risk you are taking and not the initial position size.