Risk management

I often write that predictions are mostly for entertainment value, and that risk management and money management are much more important.

For traders, risk management involves right sizing of positions, entry points and exits. Let's take an extreme example to make a clear point. Say there is a hypothetical trade that will win 90% of the time and generate a 20% gain on each win, and 10% of the time it will lose 100%. If a hypothetical trader bets his/her entire account on each trade, eventually they are sure to lose everything when that 10% chance comes up. Instead of betting everything, if the trader bets 10% of their account value each time, they will have nine winners of 20% each, and one loser at 100%. Overall this is a 80% gain on the size of one position or 8% of the entire account value (9 x 20 - 100 = 80).

Also important for traders is the concept of draw down--what is the lowest point the trade is at? This is doubly important for those like me, selling options, because margin calls can come into play. What good is a hypothetical winner at expiration if a forced margin call takes out the position before that winner comes in?

For long term investors, Random Roger occasionally writes about active management vs. indexing, and performance at his blog (link). In a similar hypothetical, say the overall market is up 10% for five years and then down 30% one year. The active manager may be said to under perform if he/she only gains 8% in the up years, and is down 8% during the down year. After all he has underperformed the index for five years, and only outperformed one year. However, the bottom line result can be a different story, depending on how much the under performance is, and how much the losses are mitigated.

Virtually all of you reading this are active money managers. The opposite is passive management with all money in various index funds.

Long SPY, TLT