Always approach any trading or investment decision by thoroughly analyzing the risk factor first. Moreover you should be of a mind that in all aspects is unemotionally acceptable for the potential of what you determine to be your total risk. Finally you must be able to absorb that risk should it become reality. The reward factor of any trade or investment should never be the catalyst for exchanging personal capital for the trade/investment! I cannot stress this critical path of risk then reward enough. Yet for almost 40 years now is still see plenty of neophyte traders as well as investors getting the risk/reward flow chart backwards.
Anyone except maybe the proverbial masochist can handle a nice reward. However the vast majority cannot unemotionally accept failure. This is perhaps why the vast majority do not have what it literally takes to become the best trader/investor that they can be.
One huge change I have seen today relative to 40 years ago when I first began my study of the markets is that this vast majority does not do the homework required for being a successful trader/investor. Instead they rely way too much on media-anointed “experts” to do their thinking and strategizing for them. Maybe they do not “have the time” or the “energy” to do that homework. I really do not care what the excuse is. I just know that to blindly follow “experts” is not wise. Know this: Professional traders cynically define an expert as someone who is 100 miles from home.
When I first began to take on what became a lifelong journey on Wall Street I knew I had to do my own homework. Much like a racehorse handicapper I kept track of various stock analysts in stock market sectors that I had determined to be worthy of my time and effort. Of course that evidence was found in the trading/investing results of these analysts. This process took more than a few years (7 years to be exact). I considered every one of these analysts as a risk and not a reward. Thus they had to prove their value to me as I kept track of them. Over time I had my “stable” of those professional analysts that I could rely upon for valid analysis, both technical as well as fundamental. However from that point on I took over the analysis, once again digging into the risk factor long before attempting to find where the reward might be found.
It is human nature to want to take a chance on being successful, especially when the catalyst for that attitude is profit. Go no further into history than the “Gold Rush” of 1849 in California for that proof. What the history of that period shows is that a small minority of those gold prospectors became rich (profitable). The vast majority who did not strike it rich probably did not initially consider the risk factor when they began their quest to find the gold. Option trading at times tends to be somewhat like that period, especially when the stock market is in an extended bullish cycle. Only when that cycle reverts back to being bearish does the risk factor ratchet up to the top of the mind hierarchy of the neophyte trader.
Risk is always best defined and accepted well before any reward is contemplated. Make this flow chart of “risk, then reward” a must in your analysis routine if for no other reason that by doing so you gain an edge on the majority!
By Skip Raschke