Today I am taking the time to give a simplified understanding of the risks involved in the financial markets from an active traders’ perspective. In order to stay safe in these markets that are fraught with danger we must first understand the definition of risk.
Risk = A situation involving exposure to danger
In the markets there are 2 major risks:
- Risk of loss (trading capital)
- Risk of loss of judgement (emotional capital)
Of the 2 major risks, many choose to focus on capital, rather than the equally, if not more important element of emotional capital. If you experience a minor drawdown does it make sense to trade? Maybe – if you haven’t exceeded your maximum loss and a signal occurs. However, if you are in emotional turmoil does it make sense to trade? I think not.
So, how do we navigate both the risk of loss and risk of loss of judgement?
Risk management = Preservation of capital and emotional capital
Risk management starts with a basic step, placing a stop loss. And ends with a basic step, place a hard stop loss (If I lose x% my strategy clearly isn’t working and I will go back to the drawing board, re-evaluate, find the cause of my losses etc.)
Here are some examples of what could come in between:
- Maximum loss on a given day
- Maximum loss on a given week
- Maximum loss on a given month
- If I have x consecutive losses within a day I will end the day’s trading
- If I don’t get 8 hrs sleep I will not trade the following day
- If I have an argument with my significant other I will not trade until it is resolved (you may be waiting a while)
This list is obviously not exhaustive, but hopefully it gives you some insight into the way that we trade and also stimulates some ideas so that you can preserve your own trading capital and emotional capital.