MONEY MANAGEMENT
Risky Business
Risk/Reward In Trading
by Don Bright
Every investor and trader has been taught to be fearful of risk in
the marketplace. That makes sense, right? You have to be cautious with
your money, right? You have to limit losses, right? Well, maybe not.
As in most other things, risk in the marketplace
comes with a counterpart: reward. These rewards can be financial, physical,
mental, or even emotional. We all risk so many things every day, from the
moment we get out of bed in the morning, head to work in traffic, engage
our peers in conversation, and otherwise negotiate our way through day-to-day
life. Even matters of the heart involve risk and reward; how many people
are too afraid of rejection to pursue a satisfying relationship? For now,
though, let's just take a look at risk and reward in the investment and
trading world.
APPLYING STOP-LOSSES
So many of my learned peers support the theory of tight stop-loss methods
when investing or trading. This seems to make perfect sense on the surface,
but look a bit deeper. If you buy 100 shares of stock at $50, and hope
to get an annual return on investment (ROI) of 12%, the stock would have
to rise by $6 annually (assuming there were no dividends paid). To protect
yourself from ruin, you can enter an initial stop-loss sell order to trigger
at a predetermined price. How much should you limit your loss? How does
this individual stock movement affect your overall portfolio?
Rather than go down the mundane road of percentage calculations based
on overall bankroll (portfolio), standard deviation of historical volatility
per stock/sector, and the whole number-crunching approach to what might
happen if the stock were to move x percent over a t time frame, let's take
a more universal and, yes, much simpler approach
....Continued in the October 2004 issue of Technical Analysis of
STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2004
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2004, Technical Analysis, Inc.
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