The Tycoon Report

For those wanting more risk, know exactly what you're taking on.

Ok, so everyone reading this has heard the common adage. If you want larger returns, you must be prepared to take on more risk. Yet its not so simple; if you want to take on more risk, you should know exactly what type of risk your taking on. As i see it, there are two basic "types" of risk. There is the chance that an individual trade will lose money, and there is the loss if the trade does lose money. There may or may not be technical terms for these two types of risk, but for the duration of this article, I'll refer to them as winning percentage and downside risk, respectively. These are like two sides of the same coin, and yet the subtle differences are very important. The first step to controlling risk, is understanding it. Or more eloquently, "Know thine enemy". Stock options are a very way good way of controlling "thine enemy", so in the study of risk, I’ll look in depth at the types of risk in various options setups.

Many people are familiar with the act of buying stock options, and most people consider this a "risky" proposition. The reason? An oft-quoted statistic; only 30% of options expire in the money - that is, only 3 in every 10 options have any value whatsoever when they expire. In other words, the winning percentage is low, and its implied that the downside risk is high. Truly a risky setup.

Another example is covered calls. That is the act of selling a call option on a stock that you already own, and typically, a good covered call will make around 5%. This is less risky then just holding the stock, because you have some downward protection against the stock dropping due to having already collected a premium on the sold option. Also, your "break even" on where you make/lose money on the stock is now lower, because you made some money on the option if it goes down. In other words... better winning percentage, lower downside risk, which means an overall lower risk. The downside to this trade is it creates an upper ceiling on your profits, because the position as a whole stops appreciating in value once the stock price is above the price of the sold call option. Yet if your willing to create an "upper ceiling" on your profits, its an easy way to consistent, high returns.

So how do you use the type of risk to your advantage? The answer depends on your situation. If the winning percentage on the position is low, you could seek to increase it by somehow altering the break-even on the trade. Going back to the buying a call option example, you could increase your winning percentage by selling a call option on the same stock with a higher strike price. The premium you collect on the farther out of the money option makes your break-even stock price lower, and so the position is more likely to expire in the money, and yield a profit. (The act of both buying a call option, and selling a call option with a higher strike price is a popular strategy known as a bull call spread. For more information, google it)

If the downside risk is high, then finding a way to hedge your position can lead to a less risky trade that still yields a high (if not as high) return. For instance, lets say you purchase a volatile stock that seems to be trading within a range of values. Your downside risk is high, but with patience, you may estimate your winning percentage to be reasonably good. In this case, a stop loss may be unwise due to the drastic short-term swings in price, and yet minimizing your downside risk with stock options remains a simple task. Purchase a put option. This gives you the right (not the obligation) to sell the stock at a predetermined strike price. The predetermined strike price is the absolute lowest you will have to sell your stock for, and (assuming its high enough) this greatly assists in controlling downside risk.

Every situation is different, yet an understanding of what type of risk is being taken will greatly assist you in attempts to control it. Awareness of exactly what your risk is assists greatly in minimizing overall risk, and maximizing your return.