'Upside Risk'

I just read this interesting article below, got me thinking. I believe to master this game one needs to have mastered the ability to not only limit their downside risk, but also be conscious of 'opportunity cost' and how much it affects one's bottom line. Maybe, you are quick to cut losers but you forfeit significant profits to let a winner run.

Anyway, its late - enjoy.


http://glynholton.com/2011/03/upsid...m_campaign=Feed:+GlynAHolton+(Glyn+A.+Holton)

Upside Risk, Downside Risk
March 8, 2011Risk

Where there is upside risk, there is always downside risk.
Risk has two components:

exposure, and
uncertainty.

If either is absent, there is no risk. But some people insist there must be a third component:

downside.

Let me explain. If you are uncertain about some consequential event, the set of possible desirable outcomes is sometimes called your “upside risk”. The set of possible adverse outcomes is then your “downside risk”. For example, if you will either win five dollars or lose three dollars based on a die toss, your upside risk is a gain of five dollars. Your downside risk is a loss of three dollars.


Based on this distinction, some people argue that, if all possible outcomes are desirable, there can be no risk. Stated another way, if there is no downside risk, there is no risk. Let’s call this the “three-component” notion of risk. It requires exposure, uncertainty and downside for there to be risk. The competing “two-component” notion of risk requires just exposure and uncertainty.
The three-component notion does reflect common usage. We tend to reserve the word “risk” for situations of possible adversity: fires, floods, diseases, accidents, financial ruin, etc. However, the third component—downside—is superfluous. The two-component notion of risk implies it. Wherever there is a dispersion of possible material outcomes, some will be more desirable than others. On a relative basis, some outcomes will be desirable and others undesirable. In this sense, where there is exposure and uncertainty, there is necessarily downside.


Three-component proponents reject this view, insisting that relative downside is not enough. They insist that there be absolute downside. As an example, consider an Olympic athlete in a final round of competition. Based on the outcome of this round, she will either win a gold or silver medal. Three-component proponents would see no risk, since both possible outcomes are desirable. Two-component proponents would see risk because the athlete would prefer gold to silver.
The three-component notion fails because it is impossible to distinguish “absolute” downside in any consistent sort of way.

Imagine you hold a lottery ticket that will tomorrow be worth either nothing or a $1 million dollars. Since no outcome entails a loss, do you face no downside risk? Suppose we take into account the $10 you paid for the lottery ticket. Based on this view, you could either lose $10 or earn $999,990. Now do you face downside risk? Suppose you were instead given the lottery ticket by your uncle. Does that make the downside risk go away? Consider still another scenario: that you purchased the ticket with your own $10, but three months ago, your uncle gave you $10, and it could be argued that it was that $10 you spent on the lottery ticket … or maybe not. Now do you face downside risk?

Suppose a pension fund implements an investment strategy that will result in its portfolio being worth either $10 million or $100 million a year from today. Most people would agree the pension fund is taking extraordinary risk, but on what basis do we consider the $10 million outcome to be absolute downside risk? Most people would agree that, from an absolute standpoint, $10 million is something to be desired.


We could assess the pension fund’s possible outcomes in terms of dollars gained or dollars lost. This approach—assessing possible outcomes relative to one’s current state—is not absolute. It can always be used to discern certain outcomes as relatively undesirable relative to others. To cite earlier examples, the Olympic athlete would prefer her current state of having a chance to win gold to the possible future state of having won just silver. You would prefer our current state of holding a lottery ticket that may be worth $1 million to the possible future state of owning one that is worthless.
This brings us back to what I said earlier:

Wherever there is a dispersion of possible material outcomes, some will be more desirable than others. On a relative basis, some outcomes will be desirable and others undesirable. In this sense, where there is exposure and uncertainty, there is necessarily downside.

In conclusion, downside risk is relative. Where there is upside risk, there is always downside risk. They are opposite sides of the same coin. The two essential components of risk are exposure and uncertainty. Where they are present, there will be downside risk. Insisting that downside be a third necessary component of risk is superfluous and—if it makes people think there is such a thing as absolute downside risk—misleading.

 

Why do you think it was interesting? What you did not know before you read it and you discovere dit from that article?

 

Upside risk is an oxymoron.

 

Because I believe we treat winners differently than we treat losers and they both should be treated equally in terms of risk. Like, when a position goes in one's favor and there is obvious resistance - that can easily become a pivot from which the new trend can erase your profits. Which is why it is ok to let your winners run but to not let fact make you complacent about the trade. I guess here is what I got out of it - constantly assessing the risk in a trade given by price action can allow one to take healthy profits and cut losers quick. Nothing new but I notice myself giving away unnecessary profits because I want to give the trend time to develop into something which may or may not follow through. And maybe its best to cover entire position when I feel like my greed is influencing my trading.