A Reasonable Way To Approach Risk

He who will not reason, is a bigot; he who cannot, is a fool; and he who dares not, is a slave.

- Sir William Drummond -

Investing is a risky business. Compared to common everyday decisions, the decisions we make as traders are far riskier. The decisions we make in everyday life involve relatively small sums. And if you buy something that turns out to be totally worthless, and for some reason you can't take it back for a refund, you're usually out only a few bucks, a few hundred dollars at most. Buying a car is a little bit more of a risk, but you're protected by warranties and by "lemon laws." Even if your house burns down, insurance often covers most of the damage. When it comes to trading the markets, however, we must take a little more risk. Sure, there are ways to minimize risk (protective stops, options), but in the end, we have to take responsibility for our decisions. The buck stops with us, and when we are wrong, we pay the price. Unfortunately, when it comes to risks, there is no way out. You have to risk money to make money. And the minute you open yourself to that risk, a whole new and unfamiliar set of emotions come into play. If we aren't careful we can experience a rollercoaster ride of
emotions: Feeling great after a win and beaten after a loss.

If you are an active trader, you know that you are likely to see many more losses than wins. We are often so consumed with losing that we feel great relief when we do win. Indeed, after making a series of wins, it's natural to feel a little elated, high, and invincible. But soon reality sets in and we find that a hot streak may end as quickly as it started. And that's why we should never let our guard down. Managing risk is a trader's secret weapon. Trading is a game of survival, and by managing risk we increase our odds of success.

What are some basic rules of risk management? First and foremost, it is essential that you trade with money you can afford to lose. Don't trade money that you need for basic living expenses. When you risk money that may impact your safety and security, you put added pressure on yourself to perform. It isn't surprising that under these circumstances, you may trade on edge and get thrown off track by even a minor setback. Ideally, you should trade with a sufficiently large trading account. A large trading account allows you to risk as little as 1-2% on a single trade and still make a substantial profit. If your account balance is low, you can't afford to risk only 1-2%, and realistically make a profit. You must risk more and there is a real chance that you can easily wipe out your account after a dozen losing trades. You can't beat the mathematics. You need money to make money. If you don't meet these conditions, then you'll have trouble trading freely and openly. You'll worry about losing and you can't take the big risk when you hit upon a winning trade setup.

A winning trader manages risk. When you take big risks, you may also make big wins, but in the long run your odds of success are limited. If you do whatever you can to manage risk, though, you will trade more safely, calmly and profitably.