Gain the Professional Trader's Edge by Understanding Risk.

10/26/09

The mission of the entire hedge fund industry is to capture outsized gains while limiting the fund's risk exposure. The success of this type of investing explains why hedge fund managers are able to earn such high fees. Institutional investors understand the risk-versus-reward dynamic and measure returns by this metric.

Part of the difficulty with managing risk is identifying all of the risks in advance. The real risks are those that are unforeseen.

Another problem with risk is that -- although it can be predicted and quantified -- there is no good way to completely hedge the risk out of the investment exposure. In any event, it is imperative that you understand those risks that are visible and are an inherent part of the investment structure that you plan to place your money.

USE LEVERAGE TO YOUR ADVANTAGE

Many investors get excited about options trading because they love the leverage they wield when the investment goes well. While stock investors might make 10% or 20% returns on a stock, options investors can make a thousand-percent return in the same time frame.

Those types of returns are achievable because of the leverage that options trading provides. The savvy options trader recognizes that he or she can control an equal number of shares as the traditional stock investor, but for a fraction of the cost.

The less-savvy trader might not realize the leverage they already wield and decide to spend as much money as they would have spent to establish a long stock position and invest it all into a huge options position. A tremendous benefit of trading options is limiting one's risk, not multiplying it, as you've seen in this example.

Thus, the problem is that the only reason why an outsized return might have been achieved is that a proportionate amount of risk was taken. The realty is that the typical option investor paid dearly for those returns by taking extraordinary risk.