The Importance of Risk Management in Trading

In our previous blog, we discussed Morgan Housel’s Psychology of Money, which references two different forms of profit: getting wealthy and staying wealthy. Housel believes a combination of frugality and paranoia is key to staying wealthy; here at YellowTunnel we believe in the importance of trading psychology to both accumulate and retain wealth. Statistics and analysis, also key elements of the YellowTunnel platform, offer a good estimate of how a certain stock or symbol can trade but “black swan” events, for example, are nearly impossible to predict. This where risk management and trading psychology are essential. 

Risk is inseparable from return. Uncertainty in the market is something all investors deal with. Risk management, in the financial world, is where uncertainty is combated during the decision-making process of investments with the process of identification, analysis, and acceptance or mitigation of these events. Correspondingly, the higher the risk the higher the potential for return. What we are attempting to do is quantify the potential for losses in an investment in order to take the appropriate action (or inaction) to support your portfolio’s return goals and risk tolerance.

Also previously covered, the importance of compounding investment can alleviate the risk you are working with. Having a trading plan, trading small, trading often, mitigating the amount of exposure, and monitoring the amount of cash you maintain are all key factors we encourage our clients to utilize. Managing target gains and stop losses are also key in reaching your portfolio goals as you work through volatility and uncertainty. Portfolio allocation, portfolio drawdown, probability of success vs return on capital, and how to manage position entry and exit are all part of the YellowTunnel trading plan to manage risk and expand profit. Risk management is associated with these returns; maintaining certain goals for returns should be factored in with the probability of loss and risk when creating a trading plan. Knowing this and being able to repeat this process successfully is the difference between getting wealthy and staying wealthy.

When creating our trading plan at YellowTunnel, we use a systematic approach based on statistics and probability of success by identifying key support and resistance levels and structuring trades with favorable risk vs reward profiles. Likewise, to manage risk we often look to hedge with VXX or SPY puts, for example. Cash on hand, also discussed in our previous blog, and the amount you maintain is also one of our principles when determining how to trade during current market conditions. 

Risk tolerance, cash, and return goals are all tied together. Every investment involves some degree of risk and is correlated to the potential return. Maintaining a vision and clear path for your targets and stop losses are essential in creating a successful trading plan. And no trading plan is complete without acknowledging risk and creating a plan to manage said risk.