In his book Strategic Risk Taking (Wharton School Publishing, 2008) Aswath Damodaran criticizes those theorists and practitioners who equate risk management with risk hedging. They have, he argues, “underplayed the fact that the most successful firms in any industry get there not by avoiding risk but by actively seeking it out and exploiting it to their own advantage.” The role of risk managers should not be simply the removal or reduction in exposure to risk; risk managers should also increase exposure to some risk. That is, risk management should encompass both risk hedging at one end of the spectrum and strategic risk taking at the other end of the spectrum.
Damodaran embraces the principle inherent in the Chinese symbol for risk: risk is a combination of danger and opportunity, and we should maintain a balance between the two. This doesn’t mean that risk is symmetric. For instance, some risks offer a small chance of an outsized reward and a high probability of a limited loss. Think, for instance, of options traders who buy very cheap out-of-the-money calls as a lottery ticket; if the stock price explodes they’ll have a staggering return on their investment, but odds are that their calls will expire worthless. Other risks present a very high probability of a small gain and a very low probability of a significant loss. Iron condor traders know this scenario all too well.
Individual traders and investors have to be their own risk managers, and this means that they have to strike a balance between believing that danger lurks around every corner and throwing caution to the wind. One way to strike this balance in the world of stocks and futures, according to common wisdom, is to put on only those trades that have a favorable reward/risk ratio—at least 2:1, preferably 3:1—although some scalping techniques, we are told, work better with a ratio of 1:2—that is, for every dollar in expected return the trader will assume a risk of two dollars. (If I recall correctly, Linda Raschke’s crew did some research and came up with this finding, but I don’t have the reference handy.)
Personally, I have never found these ratios particularly useful, though I have no doubt that the successful scalper has to be keenly aware of what ratio works best for his strategy especially in this era of high-frequency trading. For the non-scalper, however, setting a target through backtesting can go only so far before his crystal ball has to take over since a reward/risk ratio divides a future value by a present value (assuming an initial stop). Will price reach a median line, a Fibonacci retracement, a moving average, or an earlier swing high or low? Maybe, maybe not. Will it blow through those targets? Maybe, maybe not. So we have a defined risk, presumably in the form of an initial stop, and a projected reward that may turn out to be illusory (the target isn’t met) or too modest (the target is exceeded).
If risk is a combination of danger and opportunity, the trader should always be cognizant of the potential downside (which is not the same as minimizing it) but not cap the upside. How does the trader accomplish this balancing act? Trade management and position sizing are critical ingredients; initial stop placement, I believe, much less so. In his annual letter Warren Buffett wrote, “Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.” We may not have buckets as large as Buffett’s, but the sentiment is applicable to all but the one-lot trader. When a trade starts to run we want to extract as much as possible out of it. We just have to make certain that we’ve removed our gold from the bucket before it starts to rain aqua regia.