The 3 R’s

2016 was a year of learning. The market was a proverbial rollercoaster, with ups and downs and twists and turns that could make even the most seasoned trader a bit sick to their stomach. As we move into the 2017 trading year, we have to look back on 2016, and the lessons it provided, as painful as they may be. But rather than reading, ‘riting, and ‘rithmetic lessons, we need to look at (dir)’rectional risk, time risk, and volatility risk (so maybe not 3 R’s but important nonetheless).

Directional Risk

2016 was the year of the rally, and that upturn has continued into 2017. But we also experienced some significant downturns in this past year (Brexit, for example). When people keep expecting the market to go up, a sudden and unexpected dip can cause massive selloffs, which exacerbates the situation.

Investors need to focus on their individual portfolios in times like these, and create a risk management plan. Don’t let emotion fuel your trading decisions. Instead, mechanically hedge yourself against losing positions to provide protection (and sometimes, additional profits!)

Time Risk

Market movement can be scary, especially if you are sitting on the losing side. Your boat is sinking into the waters, and there isn’t any help in sight. It then becomes the question: how long do I hold onto the sinking boat? What if the Coast Guard comes right after I let go? What if no one ever comes? As traders, it can be tempting to simply sit on a position, and hope that time will save you. But time can also lead to more unfavorable moves and even larger losses.

That’s why we need to bring our own lifeboats. Creating smaller, short-term profits, rather than relying on long-term directional profits can give us the support we need when our account is going underwater. Look for OTM options that have a high probability of expiring worthless to collect some premium to reduce the breakeven point on your longer-term trade. Doing this will ensure that you can stay afloat, even in the stormiest of weathers.

Volatility Risk

As one person put it, volatility was like a whack-a-mole game in 2016. It would pop up, only to go back down again. “The market dropped and the VIX popped”. So now, the market is on a rally, and the VIX is back down in the hole. As traders, we like higher volatility, as it allows us to collect that premium we so desperately desire. But, when vol is low, we still have to stay active. Implement a debit spread, or a calendar, and take advantage of the eventual volatility expansion, even though credit spreads are much more fun!

Overall, the biggest thing that we can learn from the 3 R’s “directional, time, and volatility” Risk (which aren’t really R’s at all) is to stay active in the portfolio. This can be hard to do, especially when you’ve been burned by the market. But the only way to become a better trader is to trade. Analyze mistakes and test yourself, and remember, that practice makes perfect.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: