Maintaining Consistency in Risk
For this article I would like to illustrate three particular scenarios which deal with various aspects of risk management. In addition to the required and necessary skill-sets involved in consistent speculative trading, maintaining a constant and disciplined approach to capital preservation is ultimately the number one objective for any professional in the field. Failure to adhere to these risk management principles will typically result in ongoing frustration and concern for any individual aspiring to attain market success.
In the classroom learning environment, I always advise my students to maintain a risk parameter of between 1% and 2% of their account balance. Therefore, should they be working with let's say a $10,000 trading account, any open trades and positions should never carry a greater potential financial loss of between $100 to $200. By sticking to this strict rule, the risk-aware trader can safely engage in the markets with control and comfort in knowing that they can endure a series of losses in the market without wiping out their account, and still have plenty of capital on hand for further upcoming trading opportunities. Remember that trading is not in essence a game of being right, but rather a strategic chess match of longevity.
As simple as this logic may sound, when a trader's emotions creep into the equation, the lines often become blurred and it actually can result in an increasing challenge for the individual market speculator to remain level-headed and focused. Consistent risk will result in consistent money management and as we will see in the below examples, will greatly affect the final P/L of all traders:
Scenario 1 – The Nervous Trader
Trader A is of a nervous nature and accepts that there is risk in trading and decides to stick to a 1% risk level on the account as this is what makes them comfortable. They take their trade, planned well in advance and place the order knowing that they have done everything they can. The result is a stop-out for a 1% loss. Moving on a few days later, they then see another opportunity in the market. Again, they risk just 1% of the account and again, the market proves them wrong. Feeling a little beaten up, even though the plan was followed through flawlessly, they decide to take a few days off and come back refreshed at a later date. Upon their return, another trade presents itself and is consistent with the trading plan.
However, as the trader is setting up the order, they remember the last two trades and start to feel uncomfortable thinking about a possible third loss in a row. So, to make themselves feel better, they decide to risk just 0.5% of the account and set the orders in place. After returning to the screen some hours later, they see that this trade worked out exactly as planned and has closed itself out after hitting the exit target. The risk-to-reward on the trade was at 1:3, resulting in a gain of 1.5%, overall. However, the nervous trader suffers because after three trades, they are still down by 0.5% as they had lost a total of 2% on the previous two losers.