100% negative outcome = No Risk
100% positive outcome = No Risk
Therefore through "a priori" reasoning we can state;
Risk = Uncertainity of a specific outcome.
Relevant to us, and our classification of RISK, we would fall under the further clarification of
speculative risk. as opposed to say
pure risk.
Within speculative risk we participate within the financial markets.
The financial markets encompassing for this purpose, Stock markets, Futures markets, Options markets, Currency markets, Commodities markets, CFD's markets.
Generalising a little, the financial markets are composed of three types of analytical participants, Fundamentals, Quants, Technicals.
Each style of analysis utilizes very different methodologies in measuring
opportunity
Opportunity is then via analysis quantified into a hard number that represents potential risk, and a hard number that represents potential reward.
As a point of separation the analysis is performed on very different analytical data inputs. Fundamentals measure and quantify
Business risk. Technicals measure and quantify
Market risk
The two sources of data provide potentially very different quantifications of Risk & Reward for the same security.
Market risk is measured by
Price
Therefore the studies as expounded via Fama et al. within
Efficient Market Theory are the benchmark that adequately explain Market risk.
Business risk is measured via
Capitalization structure, Operational results, and Intangibles and as a consequence pays no heed to
Market risk
Thus, cannot be included within
EMT
This has given rise to further theories that operate in tandem with EMT, and have simply been labeled
Inefficient Market Theory the irony being that if both operate as postulated, that in
longer timeframes, you will achieve a true EMT
Intrestingly some common words keep cropping up that are used out of the correct context;
Probability
Refers to the mathematical concept of
statistical significance
If you use "PROBABILITY" within your argument of RISK, you are really saying that you have
designed a statistical model for your theory, that conforms to rigourous statistical methodology, (which uses the Law of large numbers) and that through the testing of this statistical model, you have achieved a result that
possesses STATISTICAL SIGNIFICANCE to a specified CONFIDENCE LEVEL
If you have not performed this work, you are incorrect in referring to the term
probability you are in point of fact referring to a completely separate paradigm.
Which is a;
Deterministic model
This is a very different model for the assessment of RISK than a model utilizing a
probability based model
Risk management methodologies
Again two separate concepts have seemingly intermingled;
Stoplosses, and Diversification
Going on a bit, often written puts are described as having unlimited risk. Therefore straight shares, must also have unlimited risk. (It's not actually unlimited because you can't go past zero, but it is unquantifyable)
This is why folks use stops. Put writers can also use stops.
This nonsense appeared on pg1.
This really demonstrates the confusion, misinformation, or plain lack of cognitive analysis performed.
Lets just break it down;
Therefore straight shares, must also have unlimited risk. (It's not actually unlimited because you can't go past zero, but it is unquantifyable)
Common shares cannot go below zero.
Therefore your risk is quantifiable, it is a 100% loss of your capital.
Going on a bit, often written puts are described as having unlimited risk.
This is dependant upon the
instrument that they are written against if they are written against common stock as a "PUT", then they have a
limited loss as once the common (the underlying) falls to zero, the loss is 100% and the losses within the derivative are also limited.
If you have written a derivative against a derivative, that is calculated on an underlying, for example a
Futures contract, derived from an underlying index (S&P500), then the loss will = 100% if and when the S&P500 index goes to zero as then the Futures contract will lose no more value, and your exposure via the written PUT against the futures contract will also = 100%
Of course there is a second factor that limits (potentially only) loss, and that is the
expiry and exercise date
The Option that exposes you to theoretical
unlimited risk, is the Naked Written CALL with a long in the future expiry.
This is true because, in theory we can not quantify risk in the same way.
The "Price" can go from $1 to $10, to $100, to $1000, to $100K per share and even further, therefore we can never write RISK = 100%
This is why folks use stops. Put writers can also use stops.
Yes they can.
However this is not a "guaranteed" or hard stop equivilent to the product listed by Maquarie with CFD's. Therefore, your risk is only managed at your eventual exit point. So excluding the aforementioned example, stoplosses are a risk management tool, but are not definitive of your ultimate risk.
jog on
d998
