Trading is all about taking and managing risk. To ensure you are using an appropriate level of risk, you need to understand how much risk you can afford to take and how you respond to taking risks. You will also need to understand how your trading method adapts to risk.
This step-by-step guide will help you better understand how to assess your own risk profile and, therefore, risk capital in an appropriate way.
This article is an educational guest post, it was written by Robert Miller
Risk appetite is different from your risk tolerance which we will get to in the next step. In the trading world, risk appetite is the amount of capital you can put at risk. In other words, the amount of money you can afford to lose without it affecting your life in a significant way.
The risk appetite for each trader depends on their financial situation. This includes the value of your assets, whether you have other sources of income, and how reliable those income streams are.
Your risk appetite will inform the maximum percentage of your trading account that you can put at risk at any given time.
To assess this accurately, you’ll need to know how much money you need to cover basic needs, pay debts, and any fixed costs. Additionally, set some money aside for an emergency fund. The remaining amount corresponds to your risk appetite, usually between 10-20% of your income for most people.
Risk tolerance refers to your comfort levels with regard to putting capital at risk. Some people are very comfortable taking on risk, while others tend to avoid taking on anything more than a tiny amount of risk.
If your risk tolerance is higher than your risk appetite, you may need to set limits and controls in place to prevent yourself from putting too much capital at risk.
If your risk tolerance is too low, you will struggle to generate meaningful returns. In this case, you will need to work on gradually increasing your risk tolerance to an appropriate level.
So how do you know what your risk tolerance is? To really understand how much risk you are comfortable with, you will need to execute some trades with real money. Start off by risking a very small amount and then increase the amount on each subsequent trade.
If you find yourself second-guessing your strategy on a losing trade, then you have probably breached your risk tolerance level. If a loss results in you being afraid to take the next trade, you are also risking too much.
The third aspect of a self-assessment concerns your personality as it relates to taking risks. Some people are risk-averse by nature, while others are more adventurous.
You probably already know whether you are a risk-taker or not. If you jump at the chance to do something like skydiving or betting on a sports event, you’re probably a risk-taker by nature. If you are more cautious and like to be in control, you are obviously more risk-averse.
If you are a risk-taker by nature, you will find it easier to trade against the trend and take trades when you may not have a lot of information at your disposal. However, you will need to ensure that you are not taking on too much risk at the same time.
By contrast, risk-averse traders prefer to trade with the trend and in a more strategic manner. The danger cautious traders face is avoiding risk on individual trades by taking on lots of small trades that have low chances of success.
Other psychological factors such as fear of losing, emotional control, fast-thinking, and impulsiveness play an important role in trading decisions.
Think about past moments in your life where you’ve been exposed to making a decision while being under pressure, and you’ll know how you might respond to it a little better.
In this step, you try to tie the previous three steps in with the most appropriate strategy or trading method. This concerns the markets or asset classes you trade, the time frame, and the amount of leverage you will use.
If your approach to trading is not aligned with your personality, your stress levels will increase, which will make it more difficult to manage risk appropriately.
If you haven’t done much trading yet, you will need to do some research about the types of trading strategies and asset classes that interest you. You can then consider how each of these relates to your risk appetite, risk tolerance, and personality.
The combination of asset class, strategy, and timeframe will also determine how you analyze the market and make decisions.
If you trade with short timeframes, you will risk less on each trade, which means you can use more leverage. However, short-term price moves depend more on supply and demand than on fundamental factors.
You will have less time and less information to make decisions. So, you will rely more on technical analysis than fundamental analysis and will need to be comfortable taking on risk without having all the information you may like to have.
If you are more cautious and like to trade strategically, a longer timeframe may be more appropriate. For longer periods, fundamental factors play a bigger role, and you’ll have longer to make a decision.
However, you will need to use wider stops, so you’ll probably use less leverage. This may require more risk appetite or a strategy that aims for higher risk/reward ratios.
Depending on the market you choose to trade, you may have more or less information to work with. The stock market, for example, will require you to process more information as there are more instruments and more information to process for each stock.
On the other hand, the forex market is driven by sentiment more than anything else. There is less information to process, but it needs to be processed quickly.
Trading a market and using a method that makes sense to you will make it easier to trade with an appropriate level of risk.
By considering the aspects of risk-taking in the 5 steps listed, you can get a good picture of how your risk appetite, personality, and trading method relate to one another. Aligning all these factors with the timeframes you can trade-in will give you the best chance of maximizing your return on risk while simultaneously protecting your capital.
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