THE HAnDbook of TECHnICAl AnAlysIsthe Conservation of risk in trading
Just like energy, risk cannot be removed, but it may be transformed into other
states of risk, that is, risk is conserved. There are four types of risk in trading,
namely:
■ (^) Percentage or Absolute Dollar Risk ($risk): This represents the risk of losing a
certain specified amount of capital when the stoplosses are triggered.
■ (^) Positional Risk: This represents the risk of a stoploss being triggered by price.
The closer a stop is to the entry, the higher the positional risk.
■ (^) Target Risk: This represents the risk of taking a lower profit due to smaller
tradesizes.
■ (^) Opportunity Risk: This represents a position that has already been risk freed.
Therefore, if its protective stop is taken out by price, the trader loses no capital
except an opportunity to make more profit.
Consider the following example in Figure 28.6. Assume that we have a base-
line setup for the purpose of comparison of risks. We now compare two setups
where the stopsizes are different. Each setup longs 100 shares. Upon comparing
risks in each setup with the baseline setup, we observe that setup A has a higher
$risk but a lower positional risk, whereas setup B has a lower $risk and a higher
positional risk. The target risk for both setups is identical with the baseline setup
and hence both setups have an equal potential of making the same profit over the
same amount of price excursion. We therefore see that setup B is no better than
setup A in terms of risk. Risk has merely been transferred or converted from one
form to another. There is no reduction is overall risk.
See Figure 28.7. We now increase the tradesize in setup B to 200 shares and
we find that setup B has now an equal $risk when compared to the baseline setup,
but now the target risk has decreased. Therefore, the overall risk is still the same.
figure 28.6 The Conservation of Risk.