Sharing a house with three boys fast approaching their teens, when I hear the words, “Hey, watch this!” I know from past experience, and countless visits to A&E, that someone’s about to do something really dumb.
Add to the mix a mobile phone that’ll record this behaviour, and you have all the ingredients you need for some genuine risk-taking.
The human relationship with risk is a complex one.
We are surrounded by risk. As I like to remind my family members, when they’re fishing around for a burnt bit of bagel – toasters kill more people than sharks.
Any activity with an uncertain outcome has a risk associated with it. It might be crossing the road … investing your life’s savings in Bitcoin … or eating a half dozen oysters.
Hundreds of times each day, we are evaluating these risks, and judging what action we’ll take.
So, what about trading risk?
How well do we think through the risks and potential rewards?
It’s not surprising that we’d be attracted to trading methods that produce high returns. We want to make money doing this, after all. But, it’s important to recognize that trading risk and reward are bed-fellows. They are both related to the unpredictability of the outcome. Therefore, higher returns will come hand-in-hand with higher risks.
You want to get profits of 200% per year? You can expect a lot of volatility in your returns.
You want profits of 10% per year? You can expect a much smoother ride.
The chart below isn’t based on any real trading systems, but shows the potential difference between a volatile, high-reward system, and something more steady …
While the volatile system makes more money in the long term, you can’t ignore that nasty drawdown in the middle of the chart. If you’d started trading just ahead of that pullback, it could have made a severe dent in your trading fund.
Each point on that chart could represent a month … or it could represent a year …
Trading systems will have good years, and bad years. So, bear in mind that a method that makes +100% on average each year, will have years when it doesn’t make a profit at all … and those losses could be steep. Of course, a system that makes 10% on average each year can also have bad years, but they are unlikely to be of the same scale.
One route isn’t fundamentally better than the other … they’re just different, and it’s good to be prepared for these outcomes. Some people would rather gnaw off their own arms that wait patiently for a couple of percentage points each month … while others would have palpitations at the thought of wild 20%+ profit and loss swings from month to month.
But what if we’ve been tempted by big rewards, but are struggling to cope with the ups and downs?
For people who have to deal with loss on a regular basis … traders are a surprisingly optimistic breed of people. Perhaps that’s why we keep on coming back for more!
And this optimism can lead us into hot water …
Most of us have gone chasing high returns, started trading a system, only to be caught out by the gut-wrenching downs that intersperse those lovely ups. Do we need to give up, and find something else? The good news is that there are ways to ‘dampen down’ a high-profit, high-volatility system to better suit our needs …
How to access those big triple-digit returns, without getting blown out by the nasty risks?
These simple steps can immediately smooth out a profit curve, so the downs (and ups) will be less severe …
- Reduce your risk-per-trade. If the strategy recommends a 2% risk per trade, cut this down to 1%. Yes, you’ll make smaller profits, but your bank will be safer.
- Start with a small fund. Rather than throwing the full £5k into a method, start with just £1k. If you suffer a drawdown, you can always top this up as you go.
- Take profits off the table. We’re told again and again that we should let profits run – and it’s true, this is the best way to make the biggest returns. But sometimes, psychologically, we just need to close out profits and get that money into our pockets!
- Trade less. If you can add an extra filter to your trades which will make them safer, trading less may bring smaller profits, but can also give you a smoother return.
By applying these extra rules to a high-return trading method, you can safely get started, build up a buffer-fund, ready to reap the benefits later on, as your fund and confidence grow.
Finding peace in a risky world
It’s too easy to find ourselves running scared of trading risk. But the reality is that it’s the same uncertainty that brings us greater rewards, as brings the risk of losses. As traders, we walk the tightrope between the risk of reward and the risk of losses – holding tightly onto our ‘trading edge’ – the magic formula that keeps us on the right side of that risk.
We have no control of how the markets will move, but there are plenty of things we CAN control in the trading realm, so smart traders will take advantage of those things …
We can control –
- The decision to enter a trade or sit on your hands
- When to enter a trade
- When to exit a trade
- What your risk is
- What you’ll do if it goes to its profit target
- What you’ll do if it doesn’t go to plan
Our trading risk is actually much easier to quantify than our rewards – so, rather than fearing it, we simply need to plan around it.
That way, we take control of our actions as traders, rather than letting the markets throw us about.
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