Developing a Philosophy

I call this section “Developing a Philosophy” but it should actually be called “Developing a Philosophy, Strategy and Determining your Risk Tolerance.” You can study 10 different traders and you might get 10 different trading philosophies, strategies, and for sure, 10 different risk tolerances. It’s also quite possible all 10 are making money. When developing a philosophy and trading style it must be tailored to your own liking and developed according to your own risk tolerance. As you read all sections of “Main Street beats Wall Street” you will learn all about my philosophy or philosophies. I think I have a great strategy and it works for me, but it might not work for you. If you and I made the same trade it doesn’t mean the result will be the same. It could end up with the same result, however, if we have different risk tolerance, which we probably will, we might exit the trade at a different point, according to our individual risk tolerance.

Risk Tolerance

Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. Risk tolerance is an important component in investing. You should have a realistic understanding of your ability and willingness to stomach large swings in the value of the investments; if you take on too much risk, you might panic and sell at the wrong time.

Let’s take a look at examples of different risk tolerance situations. Someone 60 years old, still working, making $50,000 a year with $20,000 in savings will have a different risk tolerance than someone 60 years old, retired, with $1 million in savings. Or maybe someone 35 years old who owns 3 successful businesses with $500,000 in the bank. All different situations. One person might not be able to risk much and one might be a little more ballsy. One might be able to stomach large swings in a position and one might not. This does not mean there isn’t a trading style that will accommodate each trader. It just means each trader will have a different risk tolerance. I would not want to see the 60 year old with $20,000 in savings, taking all his savings and making a high risk trade. This would not be prudent, it would be pure gambling! Trading options can be very high risk and there are plenty of strategies that are very low risk. This is what makes options so great. There is a strategy for everyone. When I first started trading options I was in my 20’s working as a NYC firefighter with not much savings. I felt a lot more comfortable trading 15 years later owning 4 businesses. I remember buying my restaurant while owning 2 night clubs. If the restaurant didn’t make it, I knew I had the clubs to carry me, so I could risk a little with the buying of a restaurant. Restaurants are risky, but my situation with the clubs gave me a higher risk tolerance. You must look at your own situation and develop a strategy with the correct risk tolerance. Also, just because someone has a lot, doesn’t mean he’s willing to risk more. Maybe someone has $5 million in the bank but if he loses $500 he’s afraid he’ll have a heart attack. Everyone is different! It’s not only the amount of money someone has, it’s his entire situation and the strength of his stomach. There is one major asset that every trader must have, and it’s totally free, that’s education. If you don’t put in the time to learn everything in “Main Street beats Wall Street” you will lose money!

The risk/return tradeoff is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty, or risk, are associated with high potential returns. According to the risk/return tradeoff, invested money can render higher profits only if the investor is willing to accept the possibility of losses.

The appropriate risk/return tradeoff depends on a variety of factors including risk tolerance, years to retirement, and the potential to replace lost funds. Time can also play an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, the ability to invest in equities over the long-term provides the potential to recover from the risks of bear markets and participate in bull markets, while a short time frame makes equities a higher risk proposition.

For investors, the risk/return tradeoff is one of the essential components of each investment decision as well as in the assessment of portfolios as a whole. At the foundation of this assessment, the consideration of the risk as well as the reward of an investment can determine whether taking action makes sense or not. At the portfolio level, the risk/return tradeoff can include assessments on the concentration or the diversity of holdings and whether the mix presents too much risk or a lower than desired potential for returns.

As you get more educated and gain more experience, you will hone in on your strategy. This may be a never ending process. You might start loving Covered Calls and start doing more Naked Calls. You might love selling Puts and move to buying Puts. You may start with In-the-Money Calls and do better with Out-of-the-Money Calls. You might be like me and from time to time do all of them according to market conditions. Only time will tell! The more you read, you will find people successful at all of the different strategies. As you read all the sections in “Philosophy, Strategy & Risk” and read my post, which will have all my trades, you will start to determine which strategies fit into your risk tolerance, and which ones do not.

Ah! Philosophy! Never really liked the subject. When it comes to the market, I am very clear in what I want to accomplish and how I want to get there. You must have a philosophy before you pick your strategy. Your strategy must be determined according to your philosophy and risk tolerance. If your philosophy is “slow and steady, steady and slow”, you might not want to buy one week options on companies with crazy high Premiums. Is your philosophy to make 10% a year or is it like mine, 1% a week? Once you determine your investment/trading philosophy, then you can determine if it fits into your risk tolerance and pick a strategy to accomplish your goals. I cannot teach you this, but with “Main Street beats Wall Street” I can teach you what I do and with your other studying you can do what is right for you. You must read all sections in “Philosophy, Strategy & Risk” and “Educational.” Let’s get to work!