How to control risk in derivatives?

If you were going to engage in some highly risky activity other than derivatives trading, you would likely spend a fair amount of time planning out how to avoid the associated pitfalls. For instance, if you were going to go sky diving it is probably a safe bet that prior to the jump you would check and recheck your parachute almost to the point of obsession. However, as I said earlier, derivatives trading is unlike any other endeavour. In derivatives trading it is not uncommon to see people run out the airplane door without even looking to see if they have a parachute. These traders usually fall into the category of new traders who are hoping to make “easy money.” However, even veteran traders who should know better occasionally fail to keep their guard up. And when they do they pay dearly. Make no mistake about the vicious nature of derivatives markets. If you make a mistake, and leave yourself exposed for one moment, the markets can reach out and knock you flat.

Why to Traders Ignore Risk Management?

The sad fact of the matter is that the majority of traders don’t get around to addressing money management issues until after they have suffered an unexpectedly large decline in equity. Part of the reason for this is that when a trader starts a new trading program his primary focus is the upside

potential and not the downside risk. Very few people get into derivatives trading simply to diversify their investments. And almost no one gets into derivatives trading hoping to generate an 8% average annual return. The only reason

to venture into something as risky as derivatives trading is to earn above average rates of return. Unfortunately, because so many traders are focused on the “upside potential” there is a dangerous tendency to either ignore

or at least downplay the downside risk. In essence, too many traders “want to believe” that they will be successful or they buy into the idea that derivatives trading can generate “easy money.” These are extremely dangerous notions.

In reality, most traders would benefit from “fearing” the markets more than they presently do. A fear of losing a large chunk of money quickly is what causes traders to keep their guard up. A lack of fear is what gets them into

trouble. In almost every other endeavour we are taught to “fight, fight, fight” and that if we persevere and stick to it we will win in the end. In derivatives trading these notions are completely wrong. If you start losing a battle in the derivatives markets your best bet is usually to turn tail and run

for cover. Unfortunately, because this kind of thinking runs counter to the way most of us have been taught to think, many traders focus on “fighting the good fight” rather than on cutting losses.

It sounds obvious, but it is important to remind yourself that once you lose all of your trading capital that’s it—you are done trading derivatives. Your very first priority as a trader is to always do whatever you have to do in order

to be able to trade again tomorrow. Anyone who trades long enough will score some big winning trades and/or enjoy some sustained winning periods. The trick is to stick around long enough to experience these trades and to

minimize your losses in the meantime so that the big winning trades or winning streaks actually put you well into the black. In the final analysis, proper risk control is the key determinant in separating the winners from the losers in derivatives trading.

Creating a Proper Risk Management Practice

The only way to create this is to plan carefully regarding the types of risk control needed for the type of trading that you are going to do and then to employ these controls without exception. To mention a few:

• Diversification Among Different Markets.
• Diversification Among Trading Time Frames and Methods.
• Proper Account Sizing.
• Margin-to-Equity Ratio.
• Stop-Loss Trades

Happy Trading!!!

Cheers.