The Best Way To Mitigate Risk In Your Trades
Many of my readers know that I’m always thinking about risk.
Chalk it up to my background in the military if you like. But regardless, it’s always at the front of my mind.
That’s why, with each trade, I recommend entering within a specified range. I probably get more questions about the range than any other topic.
The range is important to limit risk.
You see, price is an indicator of risk. I’ll explain this with a hypothetical example.
What Price Tells Us About Risk
Let’s consider two companies, each earning $1 a share. Company A pays a dividend of $0.30 a share and has paid that dividend for the past 30 years. Earnings are growing at 3% a year and the company has exceeded analysts’ estimates in each of the past 20 quarters.
Company B doesn’t pay a dividend. Earnings per share grew 150% in the past year, after years of losses. Management has delivered earnings that missed expectations in 10 of the past 12 quarters.
Company A is priced at $10 while Company B trades for $40.
We know Company B is a riskier investment. And as odd as might sound, the market is telling us that the higher priced stock is riskier.
To make it easier to understand we usually place the price in context. Company B’s price-to-earnings (P/E) ratio of 40 is higher than A’s P/E ratio of 10, so we know B is riskier.
This is what I mean when I say price is an indicator of risk. It must be combined with other information to evaluate the relative risk of a trade.
How To Apply This To Your Trading
I use models to determine the risk of all my recommendations. I require a relatively high probability of success before I recommend any trade. The recommended range is based on this factor.
If we enter a trade below the lower limit of the range, then we aren’t being paid enough to accept risk. Entering above the upper limit of the range means there is more risk.
Here’s what that means… It may seem like an option trading above my recommended range is more attractive because it provides more income, but that option is actually riskier at the higher price than it is within the recommended range.
This doesn’t mean you shouldn’t trade outside the range. If you are aggressive, opportunities might be appealing above the range. Conservative income investors might want to always trade below the range.
Often, the price will move above the range because of market conditions. I evaluate the risk of all positions daily. If risk rises too much, I will recommend closing a trade. That is rare. Usually risk rises to a level that is acceptable.
In notional terms, I recommend trades only if the risk of a large loss is less than 10%. I will not recommend closing the position just because the risk rises to 20% but I also will not recommend buying at that price.
How I’m Trading Right Now
These are all factors that went into my recent recommendation of a trade in Walmart Inc. (NYSE: WMT).
If you take a look at the chart below, you’ll see that the stock is breaking out of consolidation and is likely to continue moving higher.
Risks are low because the option we traded is attractively priced. And the stock is unlikely to decline much even if the broad market sells off. That’s because the company has already demonstrated that it can continue operations under pandemic conditions.
I’ll save the specifics on the trade we made for my premium readers. But just know that if you’re not already thinking about risk in dynamic terms like this, then you could be in for a lot of unnecessary pain in your trades.
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