All of us are willing to accept different levels of risk. This is true whether it's buying a home, a pet, having children, developing a relationship, or on the job.
Risk becomes a much different thing when we are considering trading in the stock market. Market changes happen not just daily, but often there are significant market fluctuations during any single trading day.
A well thought out and implemented trade plan, while it will help minimize risk, there is no such thing as a stock market trade that lacks any risk at all. The following scenarios are possible when trading in the stock market:
Make a profit on purchase/sale
Break even on purchase/sale
Lose fees and charges from broker on purchase/sale
Lose part of investment on purchase/sale
Lose all of investment on purchase/sale
A) Make a profit on purchase/sale
In order to secure a profit on the purchase and sale of any stock market investment (or other investments) you must sell at a higher price (including fees) than you purchased the investment for.
B) Break even on purchase/sale
You purchase a stock at 12.75 per share and the fees you incur from your broker add up to about 1.25 more per share and you sell your shares at 14.00 per share resulting in a break-even trade.
C) Lose fees and charges from broker on purchase/sale
You purchase a stock at 12.75 per share and the fees you incur from your broker add up to about 1.25 more per share and you sell your shares at 12.75 per share resulting in a loss of fees and charges on the trade.
D) Lose part of investment on purchase/sale
You purchase a stock at 12.75 per share and the fees you incur from your broker add up to about 1.25 more per share and you sell your shares at 12.00 per share resulting in a loss of fees and charges as well as .75 per share on the trade.
E) Lose all of investment on purchase/sale
This is a scenario that many traders will not have to deal with, although many options traders face this scenario on a regular basis. In a stock (equity) trade, this would occur only if you owned shares and a company went bankrupt, but in an option trade, you may purchase an option which may expire with no value (and unable to be exercised) resulting in a complete loss of your investment.
When determining your risk threshold, you will want to take into consideration the following;
How much am I willing to invest per trade
Am I willing to risk losing 100% of my investment
can I afford to take the risk of losing 100% of my investment
How much am I willing to invest per trade?
Clearly the more you are willing to invest, combined with the risk you are willing to take will have an impact on potential profit. As a rule of thumb, the higher the risk the higher the reward, and therefore the more you're able (or willing) to invest the more you are likely to gain (or lose). When determining how much you are planning to invest in a single trade sees how it first fits into your overall trade plan and carefully weigh the risk and the benefits of that trade.
Am I willing to risk losing 100% of my investment?
If you are unwilling to risk a 100% loss on a single trade, then you should not be considering an option trade. Since options pose specific risks, there is always the possibility of losing 100% of the investment in that instrument.
Can I afford to take the risk of losing 100% of my investment?
It is critical when you are setting out your preliminary trade plan that you carefully evaluate your personal financial situation. It is not a good plan if you are risking funds that you cannot afford to risk.
Clearly, those investors in their 20-30's have a 'higher' risk tolerance than an investor in their 50's or 60's. However, a good trade plan (designed by you with advice from your financial advisor if needed) should take into consideration not only your risk, but should also take into consideration your age. Lowering risk as we near retirement is simply smart investing.
