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Hey y’all, To me, one of the most important things for any new trader to understand is risk. And with all the downside we’ve seen recently, I thought that it would make for a particularly juicy topic. When I talk about understanding risk, I mean traders need a real, living, three-dimensional understanding of how risk works in trade. For instance, at first blush, it might seem like a trade where you risk a 100% loss is always a bad idea, right? But actually, I think trades where you risk a 100% loss are often the smartest, most controlled trades you can place. Let’s dive into why… Let’s look at an example of risk so we can understand this a little better. Let’s imagine you have a $100,000 trading account, just for a nice, round, simple number. Which risk would you rather take:
Or
Now, there are actually a few things to consider here. First, you need to look at your max loss… In Trade A, your max loss is $1,000 — or 1% of your account. In Trade B, your max loss is 50%, or 5% of your account. The good news is, neither of those trades are wildly self-destructive or risky. Geof Smith always advises that you should never risk more than 10% of your account on a trade, so even Trade B stays well under that threshold. With that said, you can immediately see that the idea of risking 100% isn’t inherently bad — it always depends on trade size. And often, using tools like spreads, you can get a better risk/reward on starting smaller stakes if you’re willing to tolerate a 100% loss. Second, you need to look at your max return… In this case, clearly, Trade B has a higher potential return. You could make a potential $10,000 return, compared with just $500 from Trade A. And that’s an important factor to remember! Sometimes, more aggressive trades are called for! But you have to keep in mind one thing I think traders too often forget… Third, you have to consider your whole portfolio, weighing two additional factors: how much time will I spend in the trade, and how much money will I have tied up in the trade? Let’s imagine Trade A is a spread trade targeting a 50% return in two weeks, kinda like Nate Tucci’s Automated Options trade. Let’s imagine Trade B is a long-term call option dated three-months out from now. In Trade A, you’re using 1% of your account to target $500 in two weeks. In Trade B, you’re tying up 10% of your account for three months. Obviously, Trade A gives you much more flexibility and ability to react to new market conditions. Does that make it inherently the better trade? No, not necessarily. I can imagine each of these trades making sense in different contexts. My point certainly isn’t that you should only use strategies that target quick returns, risk 100% losses, or anything like that. But my goal is to encourage you to have a more broad-based understanding of risk. We often get questions in our webinars from a place of fear: “why aren’t you placing stop losses?... are you really risking 100% with each trade?” I understand these questions and where they’re coming from. But they do display a lack of a deeper understanding of risk. I hope this quick newsletter has helped broaden your personal understanding a bit and, if it has, please feel free to spread the word! |
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ABOUT US: We believe that the opportunity for financial literacy and freedom belongs to all people, not just those who already have years of investing experience. Prosperity Pub provides an array of educational services and products that will help you navigate the markets and become a better investor. Trading is made simple through our online forum full of trading techniques to give you the best tools to kick-start your investing journey. We offer collaborative webinars and training; we love to teach. No matter the opportunity, we bring together a strong community of like-minded traders to focus on analyzing market news as it’s presented each day. |
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