Almost by definition, if you are investing in the stock market, you are taking on risk. Investors accept some amount of risk in order to realize expected returns above that of the prevailing risk- free rate. It’s a fundamental reality of investing, but it is easy to forget there is no such thing as a free lunch. If you want higher returns than you get from the Treasury rate, you have to give up some of the relative certainty that risk-free investments afford you.
There are libraries filled with books and studies of risk versus return. They speak volumes on the efficient frontier of the risk/return trade-off; Sharpe ratios that quantify excess returns vs. risk taken; benefits of diversification in risk reduction – to name but a few. The idea of taking risk in a measured way to gain extra return is a bedrock investing principal. During my time on the proprietary trading side of the options business at OptionsHouse’s parent company, PEAK6, we measured risk along several key parameters: time decay, dollar deltas, exposure to volatility, and more. The absolute numbers were not very helpful unless they were given in context to the size of the portfolio the trader had. For example, paying $10,000 per night in time decay might be a dangerously large position for a junior trader because he or she probably only had a small amount of capital at his or her disposal. However, for a senior trader who was using substantially more capital, this could actually be considered a flat position.
With this in mind, we at OptionsHouse strived to create a way to proactively show you risk metrics as they relate to the size of your own portfolio. Think about it as having your own personal risk manager riding shotgun with you through your investing day. Some of the measures are very similar to the ones I used for years on the proprietary trading side of the business, while others are specifically designed with the needs of retail investors in mind. Building this was not easy. There is an enormous amount of complexity in running these calculations throughout the trading day. However, when you change your portfolio, you need to immediately see how your risk profile has also changed. These risk metrics are meant to be guides for you. We provide you with the platform and the information to help you make your own trading decisions. That said, with 40 years of trading industry experience between Steve Claussen and myself, we’ve experienced many of the situations that our customers face every day, including the ones that can get investors into positions of unacceptable risk. We urge you to use the new Risk Score functionality as an educational tool to expand your awareness and understanding of risk. You might be surprised about what you find. Please understand, however, that the use of any educational tool or investing alert should not be the sole basis of your investment decisions. Instead, please be sure to conduct your own research and individual portfolio analysis when deciding what investing action to take.
In thinking about investing or trading over a long period of time it is important to remember that you are going to be wrong sometimes. No one has a perfect track record of investments and that is ok. It is imperative that you understand how adverse events will affect your portfolio before they happen. For example, it is acceptable if you are long stock in XYZ, and a negative earnings pre-announcement causes a 20% down move in the stock. These moves can happen to the best traders. However, you should never be surprised by that move’s impact on your portfolio. When you read the headline about a negative earnings pre-announcement, you should know a) you have the affected name in your portfolio, b) you are long the affected name, so this news is bad for you, and c) a reasonable estimate of how much that loss will be in relation to your overall account. This is what we are doing with the Risk Score. We are giving you a guide to how much risk you may be subject to for potential events so you are not surprised by their impact should one or more of them occur.
How does the Risk Score work?
We have tried to provide you with a standard framework for each measure of risk that will give you a sense of how your portfolio might look through the eyes of a professional risk manager. For instance, we believe a score in any scenario of 4 is within the bounds of risk that a reasonable investor might take in a fully invested portfolio. This assessment has absolutely nothing to do with an opinion on whether or not you will make money. It’s sole purpose is to highlight risk against a specific set of criteria. As you already know, there are countless decisions and viewpoints that go into forming your investment quality outlook. That is your job, not ours.
Many of our metrics are about degrees of concentration your portfolio is exposed to, which you may or may not be aware. As our name indicates, many of them have a concentration on options-related risk. If you have a score of 0 or 2, we believe your risk is not especially high for the size of the account you have. Again, that is against our specific criteria, not all criteria. Finally, and importantly, we think scores of 6 or higher should be considered warnings that you may be overextended.
Two important things to keep in mind: 1) Stop orders you may have in the market are not currently considered within the risk metrics because you are still at risk to a gap move outside of market hours when it comes to your stop. They are good to have, and they can often get you out of positions, but they are not foolproof; 2) These measures are account-specific. You are responsible for monitoring risk for each of your accounts.
To find additional information on Specific Metrics, please visit this link.
When discussing commodities-based stocks, there is usually correlation between the underlying commodity and the company’s share price. As most of you know, there has been a pretty large rally in commodities stocks over the last few months. Gold and copper are near all-time highs again. Freeport-McMoRan Copper & Gold (NYSE:FCX), the copper mining stock, has followed copper higher to hit an all-time high of its own. The stock is now trading around $115.
Early last week, I saw an 
Netflix (NASDAQ:NFLX) reported earnings Wednesday night that were viewed favorably by the Street overall. The stock was up 13% on Thursday to $173. Obviously, traders who were long NFLX stock or long a lot of deltas through a combination of long calls and/or short puts fared well in their portfolios for the most part. Conversely, those who were short delta exposure probably had a tough morning.
Despite the strongest September in nearly 70 years, the market has yet to recover to its early-May levels – the area at which stocks were trading before the infamous May 6 “flash crash” that took the Dow 1,000 points lower in a matter of minutes. It’s been almost five months since this unsettling event, and officials are still looking for a culprit.
I found it interesting that Warren Buffett was 
