What is risk management?

This is the first article of a 4-part series of articles on risk. I often hear people saying stock markets are risky. I am going to try and classify and quantify the risks that they perceive. Once they know what to and what not to be afraid of, may be the fear will subside a little.

We all have heard the following;

‘MutualFundsAreSubjectedToMarketRiskReadAllSchemeRelatedDocumentsCarefully’

Not just the adverts, but you all will have at least one each from the following categories in your friends and family:

The one who is terrified of the thought of stock market and actively advises everyone against it.

The one who has tried and burnt her hands in stock market.

The one who’s doing it for a long time but has neither made nor lost too much money.

The one who knows what she is doing and makes consistent money from the market.

The last one is very rare and usually flies under the radar. Except the one who has lost a lot of money, everyone else of the above have done a decent job of managing their risk. And yes, I am including the person who stays away from the market, since she has already made sure she never makes a loss in the market. (There are other ways she will lose her money but we will talk about it in subsequent articles).

If you look up the definition of risk management, you will find something along the lines of identifying and mitigating threats. That is a generic definition. Let us rephrase it to suit our profession. The overarching risk in securities market is losing money. And why do we lose money? Usually because our view of the market is wrong or the tool that we used to express our view of the market is wrong.

You can have 7 views for the market:

  1. Up
  2. Down
  3. Sideways
  4. Up or sideways
  5. Down or sideways
  6. Up or down.
  7. Arbitrage – This is not a feasible stance for most retail investors so we will ignore that.

For example, if your view is that the market might stay sideways, but market makes a directional move beyond your expected range you will lose. Your risk management principles will dictate how much you lose when your trade goes wrong.

I would like to give an example of picking the wrong tool for your directional view as well. Let us say your view was that Reliance will move up in the next 30 days. Instead of buying shares you thought you’ll receive higher ROI if you take a position using options. You buy an OTM call. For half the month Reliance doesn’t move up very much. Due to theta decay, your option loses premium and the stop loss on the option’s premium is hit. You exit the position and a couple of days later Reliance Starts an explosive rally on the back of some good news. You could have held on to the position if you had made a spread with options or simply taken a cash position.

We will talk about many factors that are often overlooked while taking a position in the next article.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.