The Risk of Trading: Mastering the Most Important Element in Financial Speculation

BUILDING YOUR RISK TOLERANCE

Earlier we discussed risk-to-reward and its relationship to trader edge. It is common to have traders say they seek a minimum of 3:1, 5:1, or greater before taking a trade. This ratio would allow a trader to be successful even with a sub-50 percent success rate. To the contrary, 60–70 percent success rate traders can get away with a 1:1 risk-to-reward, or risk the same amount as their profit target. Traders spend a lot of effort studying the relationship of the two and still find themselves bewildered when their capital bleeds a slow death.

No doubt understanding risk and reward is an important part of trading. It is one of the primary principles of this book. The element that traders often overlook is that risk in itself must be contained regardless of reward. You can run simulated back-testing all year and have a positive outcome, but the game is over if one trade has a loss larger than your capital account. It is your capital tolerance and your personal risk tolerance that must supersede any back-testing drawdowns. To manage this risk effectively, we first must understand the maximum loss we can expose ourselves to on any given trade, series of trades, or time period. The ultimate goal of professional trading is to have the ability to sustain your business during periods of adversity. Understanding how to manage your business during these trying times will allow you to reap the benefits when your numerical edge reappears.

The first step to understanding ...