Creating Risk Parameters for Your Trades

My best advice about determining your risk parameters should begin with two main factors;

1. Your motivation to trade, and
2. The amount of money you are trading with.

These two factors will become the foundation of your risk parameters. The most important factor is determining the ‘why’ behind the risk you are taking in the market. The reality is that all investing involves some degree of risk and while most traders are motivated by making more money, I would argue that you will need to define your motivation in deeper terms than that. I suggest this because, as a trader you need to be motivated to trade when you are making money, and when you are dealing with trades that are losing money. If all you focus on is ‘making more money’ as your motivation, you will quickly become focused on every dollar gained and lost. This type of mindset will often lead to burn out, too much stress or blown up accounts. Everyone wants to make money trading, this is obviously the goal, but this needs to be connected to something bigger.

Motivation to trade that is routed in elements of:

  • pride in your ability to find and make money in the market
  • teaching yourself the skill of trading
  • identifying better trading opportunities
  • mastering the trading skills you have acquired

Are probably the best mindset for continued growth (both in terms of profits and long-term trading success). Remember, I’m not saying that profit earned and dollar amount risked isn’t important, I’m just stating that it can’t be the only focus.

Once you have established your motivation you will be able to use this information to consider other facets of risk. The questions below are meant to help you reflect and be able to help you articulate why you are choosing to trade:

What kind of money are you trading with?

This question usually leads to some reflection about your emotional connection to money and its value. If you are trading with some extra money that you have saved up, or that you got from a work bonus, your emotional attachment and expectation may be different than if you are trading with money for retirement. Each of your emotional attachments will support the way you will think and react to trading decisions. If you are trading in your 401k, your trades should be more conservative and reflect a conservative approach to trading. Ask yourself, can you afford to lose this money?

How much money you are trading with?

Regardless of whether you are trading with $10,000 or $500,000 the trades in your account should always stay aligned with the size of your account. It just isn't a realistic goal to say that in 30 days you will make $5,000 trading with a $10,000 account. Everyone would love to double an account in one month, if it were that easy…everyone would be doing it! Your profit goals should be aligned with the size of account you are trading, remember even if you make 100% on $5000 it’s around $416 per month, does this satisfy your financial needs? I’m not saying not to trade with a $5000 account, just keep the dollar gains in perspective, a rock solid 20% return is about $83 per month.

Think about how you would feel if you lost everything in one trade, how would that make you feel?

Most people will naturally think about how great it feels to make all sorts of money with the account they are trading, but not think about how they will feel if they lose the money. Your profits will help you to dream and create goals to work towards, but you also need to consider what might happen if the money is lost in trades. The reality check of deciding your ratios based on what you can lose will help you keep your ratios realistic. Your goal should be routed in the steady increase of your account size over time. A good rule of thumb is not to risk no more than 3-5% of your account in any one trade, this way no one loss will make a huge difference in your account.

What is your rate of expected growth over time?

In order to have a steady growth rate over time, it is obvious that you can't have 100% of your account tied up in trades. If you had all your money tied up in trades at one time, you risk losing all your money at once. By having all your capital tied up you are also unable to place further trades and take advantages of those opportunities. New trades will emerge throughout the week and you need to keep some "powder dry" to take those trades. Your expected rate of growth should not be based on your total account size, it should be based on the capital you are putting to work every week.

These factors are key to successfully managing your risk parameters. Understanding these parameters will then help you decide how much money you are comfortable putting in to trades at one time. This is a personal decision, and one that should be thought through carefully.

In order to be successful as a trader, all of your trades need to add up to more profits than loses. So for example, if you have 5 great trades where you make $50 in each of the 5 trades but 1 bad trade that loses $250, then you are left with no profits, in fact you will owe money to your broker in commissions. Options trading in particular can lure traders in to very small gains with large risks, and while the probability of the trades can be above 90% (when you trade at 2 standard deviations away by selling credit spreads or iron condors for example) the results at the end of the month may be surprised to be at a net loss at the end of the month when one trade too away all of the profits made in previous trades. Remember, you are working to find trades, and spending time paying attention to the market. You want to be paid for your time and this should be in the profitable returns.

If you keep your goals reasonable and trade with money that is not crucial to your survival you will have a much better shot of being able to make some good money each and every year. Mindset is important if you are trading with money you can’t afford to lose you are not setting your self up for success.

Moderation is the key to most things we do in life, it is no different with trading. Understand your financial constraints and if you have the personality to trade. If you want to make an extra $1,000 a month on a $100,000 account you might get there by the end of the year, however if you want to make $25,000 on a $5,000 account, you might have a challenge ahead of you. Trading can be rewarding and can develop in to a long term active investment strategy if you put the time and effort in to learning how to do it with achievable goals.

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