Build confidence in trading
Lesson two: Risk management and risk tolerance
Having a game-plan for how you handle risk is more important than the analysis itself.
You can’t trade properly if you don’t know how much risk you can tolerate or how you’ll manage risk. The amount of risk a person can tolerate is highly dependent on the individual. When a trader exceeds their risk tolerance, they lose objectivity and become far more prone to making mistakes.
Consider the risk to your whole account…
The first step to understanding risk is to know how much money you can stand losing. How much capital to trade with varies from person to person and their personal financial situation. Knowing your personal tolerance will help put your mind at ease and allow you to focus on making good decisions.
…and then consider risk per trade
When doing your risk planning, you have to assume there will be times when you will have a string of losing trades, or a drawdown. If you have 5,6,7 or more losing trades in a row, can you accept the accumulation of losses? Accepting the worst possible outcome beforehand will help you keep your head in the game when faced with adversity. In the immortal words of George Soros, “It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.”
Did you know?
Experienced traders often risk only 1-2% of their total trading capital on any single trade, allowing them to withstand numerous consecutive losses without significant damage to their overall account.
Seek out opportunities with good risk/reward ratios
Look for trades where you can profit twice as much if you are right than you will lose if wrong. Right off the bat by striving for good risk/reward opportunities you reduce the percentage of the time you need to be right. For example, excluding transaction costs, a trader who achieves a risk/reward ratio of 2:1 only needs to be right ±34% of the time to achieve breakeven, whereas with a trader using a low risk/reward ratio of say 1:1 must be right 50% of the time just to achieve breakeven. By seeking out more fruitful opportunities on a risk-adjusted basis, you alleviate the pressure of being right.
Here is a good question to ask yourself prior to entering any trade set-up: Can I accept the loss on this trade if it doesn’t work, or will I be upset with myself for losing on a trade I should have never been involved with in the first place?
If the answer is yes, it is likely you are taking a trade which fits within your game-plan. You will be surprised by how many ‘bad’ trades you will avoid by asking yourself that simple question. It’s worth noting at this time that a ‘good’ trade can be unprofitable while a ‘bad’ trade can be profitable. Remember, this is a probabilities game, and over time you are far more likely to be successful if you take only ‘good’ trades and reduce the number of ‘bad’ trades.
Question
Question:
What is a key benefit of trading with a 2:1 risk/reward ratio?Correct
Incorrect
Correct answer: B) A trader who achieves a risk/reward ratio of 2:1 only needs to be right ±34% of the time to achieve breakevenHow many open positions is too many?
Limiting the number of open positions in your account will keep you focused. When carrying multiple positions, it is important to know your total risk if all your positions were to reach their stop-loss. You might be willing to take on one level of risk per trade but realise with several positions the risk is more than you are willing to accept. Understanding how the markets you trade are correlated is very helpful. For example, if you are long or short three Yen-crosses, you effectively have one larger position. The position size for each then needs to be adjusted accordingly to reflect this.
Lesson summary
- You can't trade effectively without understanding your risk tolerance
- Consider both overall account risk and risk per individual trade to maintain objectivity during drawdowns
- Seek opportunities with good risk/reward ratios (aim for 2:1) to reduce the percentage of winning trades needed for profitability
- Limit the number of open positions and understand correlations between markets to keep total risk at acceptable levels
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