Understanding your risk appetite and the risks in trading

Is understanding your risk in trading the most important part of your trading journey? This simple concept is easy to get on paper but has been the downfall of many traders who have failed to grasp the intricacies of the risks in trading. The secret to successful trading is capital preservation and growth by using risk mitigation techniques every day. By controlling your losses and managing your winners, you will understand how to deal with risk, protect your capital and keep you in the ‘game’ for longer. And fundamental to this whole process is our individual attitude to risk and what our risk appetite is.

What is risk?

Risk in the context of financial markets is:

• A measure of the potential for losing money
• It describes the uncertainty of the returns on your trade
• On the one side, there is a probability of losing part or all of your initial deposit
• While on the more positive side, it can be a gauge showing you the potential reward, the 'upside' and the profit you could make

It follows that the greater the risk, the greater the potential reward and return on your trade. After all, you wouldn’t put half your trading pot into a trade where you didn’t believe you could get far greater rewards back, would you? If that sounds fairly obvious to experienced traders who know it’s more important to focus on what they could potentially lose, new traders tend to think about how much money they can make, with much less regard to the downside risks.

Risk Appetite: Personal attitude to risk

Psychologists tell us that many people form their relationship with money by the age of seven and this can affect us throughout our lives, even when personal events may be far removed from childhood. That we are trading no doubt does mean we appreciate there is some risk involved and that we are willing to risk some of our money to potentially increase our capital.

Of course, no two traders are truly the same. Some risks in trading are common to everyone but not all risks can be universally applied to all of us. Try entering a few trades in exactly the same instrument at the same time as other traders and see what happens after this, once you all have live positions.

• The trade quickly goes into profit, so do you all agree on when to exit the trade?

• Do some of you want to run the position, for greater profit (which could turn into a loss) as you are comfortable with the risk?

• Or are some of the group more than happy to close for a quick profit?

This scenario sums up how each of us may determine risk and return differently. Past experiences, upbringing, goals and our own needs all help determine our understanding of risk in trading. The capacity to cope with adversity is also another important factor brought to the trading desk that can often affect the ultimate outcome.

So, it is important to understand your personal tolerance of risk in order to determine what sort of risk appetite you can manage and what style of trading is right for you. For example, day trading and scalping suit those who trade multiple times intra-day and exit trades quickly. Whereas swing traders can hold single positions over a much longer timeframe, with all the inevitable highs and lows that entails.

Risk Tolerance: How much to risk?

The question of how much to risk is answerable by asking what it would mean if your trading capital fell in value and affected your plans and living standards. As a trader, you will inevitably have times when your positions are offside and losing money, even when you have followed your plan. How long it takes to recover from this downturn, both financially and also psychologically, will determine your way of managing and understanding your risk in trading.

Preparing and responding wisely for these situations should in no way hurt your long-term success. Indeed, it often ‘makes’ a trader and proves they are secure in understanding what risk means to them, their trading style and size of trade. They have gone beyond those times when they are forced to trade to make up losses or earn a certain amount of money in a specific time period.

Your Trading ‘Comfort Zone’

Risk tolerance often varies with income, age and long-term financial goals. Your ‘comfort zone’, the amount of risk you are comfortable taking, can sometimes be measured for investors by a variety of tests and questionnaires which are able to determine, ultimately, if you are ‘comfortable sleeping at night’. That said, many a full-time trader has been kept awake at night analysing all the different scenarios around their current positions! Does that mean they are uncomfortable with the amount of risk they are holding or simply that they are in tune with the market environment and planning for all eventualities?

The balance of risk in trading is key and this question should be answered before live trades are entered into. When the amount of necessary risk exceeds the level the trader is comfortable taking, a shortfall most often will occur in terms of reaching future goals. The flip side to this is when risk tolerance is higher than necessary, then undue risk may be taken by the trader.

Financial planning, alongside understanding your own situation can help you as a trader figure out your ‘comfort zone’. This may require some self-discovery on your part, asking some searching and realistic questions about your own goals and overriding motivations. When personal feelings are dominant, reason and judgement can be confused so an outside voice or a professional trading coach can be very helpful.

Risks in Trading: Market Specific Risks

Different markets, trades and investments will inherently be more risky or less risky. If you don’t understand the nature of your chosen instrument, it will be more difficult to accurately measure and assess the risks in your trading. The main types of specific risks in markets include:

- Systemic Risk

The risk of a collapse in an entire market was a major contributor to the financial crisis in 2008. Although this is very rare, diversification can be used to mitigate against major crises. This entails trading different instruments which are uncorrelated and using hedging strategies to spread your risk.

- Specific Risk

This relates to individual asset classes, in contrast to systemic risk. Traditionally, investors consider bonds to hold less risk in trading than equities, while forex traders may consider different currency pairs to have similar characteristics of varying risk.

For example, trading AUD/JPY means you buy and sell the high-yielding Aussie versus the safe haven Yen. This is more volatile and so risky than trading EUR/CHF, two currencies which have historically tracked each other quite closely.

- Volatility Risk

This is risk due to unpredictable changes in the price movement of your chosen instrument. Even liquid assets can be prone to big shifts in price but predicting when this may come and by how much can improve your trading. Would you trade over a key US data release or a central bank announcement when you know volatility will increase substantially?

- Liquidity Risk

When markets are very volatile, the ability to buy and sell may become more difficult as buyers and sellers pull back from trading. This implies there is a chance that you have to trade at a worse price than you expected. Small-cap stocks can experience this from time to time, but forex markets are generally exceptionally deep which means you can trade 24 hours a day.

Understanding Your Risk in Trading

The most important investment you can make is in yourself.

The Sage of Omaha, aka Warren Buffett, CEO of Berkshire Hathaway, has uttered many famous lines while watching and participating in financial markets. As one of the greatest investors of our time, this phrase seems highly appropriate when thinking about our understanding of risk and return. For it is our experience around risk, knowing ourselves, the market and our appetite for risk which will determine our own unique approach to trading.