Return on RISK!!!!

Thinking of profits in function of return on risk is unconventional, we are all used to return on capital, because most of us start our carriers buying stocks. We hardly ever think of putting a stop loss at 15% on the stock price and that it is precisely that 15% of our capital that we truly have at risk. If you buy 100 shares of AAPL at $135/share, we are using $13,500 of capital, but if we put a stop loss at $114.75, we are really risking only $2,025, not the whole $13,500. The buy and hold crowd hardly ever would close their positions after such a decline and when the stock has collapsed, like it happened in the early 2000’s, they would justify their approach by saying, “I am a long term investor”. In such cases, it makes sense to think it terms of return on capital invested. Or does it? Let’s say now that you bought AAPL at $12 back in 2003 (the stock has split since, so assume you could have bought at $6). You would have paid $600 for the same 100 shares. Are you really risking $600 at this point? Or are you risking $13,500 profits and all? Remember now, your profits are only on paper until you sell. The long-term holding crowd would say that it is cases like AAPL that they live for, a 2250% increase. But as AAPL goes higher, is your return on investment getting riskier? Of course it is. You are no longer betting $600, you are betting $13,500, and your chances of even doubling your money (let alone a 2250% return) are low, at best.

Although many would argue that you would have not gotten the 2250% return with stop losses, we as traders must deal with risk management, if we intend to survive in our business. Perhaps we could have entered and exit AAPL 20 times between April 2003 and Dec 2007, and multiply our gains even further. However, we would NOT look at our trades as a $600 risk, but as a new risk with every new trade. What we really risk is not the whole bag of capital needed to buy 100 shares of AAPL. But if you bought 100 shares AAPL at $200, less than a month ago, your $20,000 would be now $13,500, a loss of 32.5%, if you did not have a stop loss. Unless you have a discipline to get out at a stop loss, you could never make it as a trader. Even if you bought AAPL at $19 in 1997 (3 or 4 splits ago), you get little comfort on the recent decline. This is why we must think in terms of money at risk, and not in terms of capital invested because we are not long-term investors. If we are traders we want to make a living out of trading, we can’t run the risk of every second stock dropping 30%. In fact, every once in a while, you are not even given the opportunity to have your 15% stop loss to take action, as a stock can fall 30% or more overnight.

Even for a good investor exiting in a timely fashion is a utopia. It is the holly grail of trading, if you will. Many claim to have the foresight of candlesticks, Bollinger bands and the Elliott wave to call the tops. They are only reassuring themselves that they have the power to profit under any circumstance. I know, I was one of them. I thought of myself as a master of the Elliott wave, Candlesticks and other T.A. indicators and methods. As good as they are, they fail so often and are so often ambiguous that decision-making is more subjective than most traders are willing to admit. By calculating your profits as return of capital at risk, you begin to think in terms of surviving as a trader, and then you begin to thrive, because you are no longer relying on your skills as a technician alone. You are now a businessman trying to weigh every trade as a source of income. Traders must think of returns in time. Because the capital can be moved around from one failed trade into a profitable one, we could put the same capital to work 10 times, 50 times, 100 times in one year. Yet, there is always risk inherent to every trade.

I think of the PCCRC as similar to stock in capital at play. If you have $135,000 in your account, you can afford to buy 100 shares of AAPL for $13,500 (this should not exceed 10% of my available capital). I should only invest $5,000 per trade if I have a $50,000 and so on. Similarly, I can safely play that 10% of my total account capital on a single PCCRC trade. In fact, when you place this much capital in a PCCRC, your maximum risk usually works out to 2% of your account. IF the AAPL trade is 10% of the fictitious $135,000 account then a PCCRC should not place more than $2,700 at risk. I am placing $2,700 at risk in a $13,500 trade. This is a 20% stop loss, if you will. If I place that amount in play by buying the stock, with a stop loss of 15%, I would not be much better protected, yet knowing that a stock can drop 30% overnight, I am really less protected by playing the stock. Not to mention the much better potential profits with the PCCRC, but that is the subject of another article.

In conclusion, the PCCRC, as any form of trading, should be evaluated not as a return on capital, but as a return on risk. The management of risk is paramount in a trader’s business plan, and the PCCRC is the most reasonable risk management tool I know.