V.6:10 (363-365): Risk vs. exposure by Philip Gotthelf

Risk vs. exposure by Philip Gotthelf

Flip a coin. What are your chances of "heads," assuming a fair coin? The obvious answer is 50/50. The probability of any event such as a coin flip is similar to the risk associated with an investment. In effect, risk is a function of probability.

This concept has become increasingly misunderstood as new investment vehicles flood the market with apocryphal labels of "limited risk." Are options really limited risk investments? What about limited risk futures spreads or limited risk penny stocks?

All too often, we confuse the concept of risk—the probability of success or failure—with the concept of exposure— the amount of money at stake in a transaction. Thus, we hear a salesman say, "Your risk is only $1,000." In reality, he is describing monetary exposure without giving consideration to the probability of success or failure.

Suppose you buy a T-bond option that has absolutely no chance of being in-the-money. In other words, the strike price is totally unrealistic. Under such circumstances, your risk would be 100%.

If we are to properly evaluate different investments using risk and exposure, we must understand how the two combine to provide an appropriate criteria for analysis.

Taken separately, proper money management dictates that we must never extend our exposure beyond our means—no matter how good the risk parameters may appear. In other words, an investor with $25,000 in risk capital should never assume a transaction that has a $100,000 exposure. Even at 90% chance for success, the exposure would exceed capacity.