Before we dive into the five steps, it's important to get a better understanding of the primary purpose of following a risk-based approach. Is it only about profit and loss and making money? Not necessarily. Rather than be held to the continuous need to be profitable, risk managers focus on the following objectives or “risk tenets” to lead them to success in trading.
1. Consistency in decision making—The ability to make decisions in accordance with chart activity or similar events that historically have provided opportunities with a favorable outcome.
2. Execution compliance—To perform more like a project manager rather than a trader. The objective here is to implement a trading and business plan effectively. A risk manager's entire belief is that adhering to such a plan will allow the manager to reach his or her trading objectives.
3. Focus on risk, not profits—Understanding that any act of speculation will involve successful and unsuccessful trades. In an arena filled with randomness, the risk-based trader needs to focus on managing the potential loss on a trade and let the decision-making variables, such as setup edge, execution, and plan compliance, dominate.
4. Mastery of variance—Understanding that speculating in the financial markets is a virtual pool of randomness. The markets are a continuous basket of different players making different decisions for different reasons. The risk manager accepts this limited ability to determine market direction and focuses ...