Establishing Your Risk Tolerance in Trading

While there are lot of possible pieces of the puzzle that you put together to make money trading, without a doubt the most important general area is going to be money management. Paramount to money management is understanding your risk tolerance in trading.

What is risk tolerance in trading?

So before we move forward, we need to understand exactly what risk tolerance is when it comes to trading. It simply means the amount of risk that you can tolerate per trade. It is a little bit different than money management, as money management focuses on the ability to survive a series of losses, while risk tolerance is more along the lines of the psychological ability to take a loss is measured.

What I mean by this is that some traders are perfectly comfortable risking 3% on a trade, while others will look to risk 0.5% on the same set up. Overall, it is a bit of a personal issue, because each person and individual trader will of course be different. However, knowing what your risk tolerance is will be ultimately crucial to your success, as if you are not comfortable in a position, you may find yourself exiting far too early. What will be even worse is that a lot of the time when you find yourself in that position, your initial analysis may be correct, and you find yourself jumping out of the market based upon fear, and not based upon anything substantial. There are few things worse than watching a position go in your favor after you have been scared out a bit.

How to determine your risk tolerance.

Determining your risk tolerance is actually much simpler than you would think. To begin with, you should keep in mind that understanding money management is crucial, so I will use a couple of examples that are realistic:

Let’s say you take a set up and risk 1% of your total account on the stop loss. If you find yourself very comfortable with this position, then you know you are well within your risk tolerance. A simple exercise would be to get up and walk away from the computer. Go on about your day and notice whether or not you are overly concerned about how the position is working out. If you can go to work, the park, or spend time with your family or friends without checking the position frequently, you most certainly are within your risk tolerance.

In another trade, perhaps you risk 2%. In this scenario, you find yourself more worried about the trade, and looking into how it is working out quite frequently. If it is causing you stress, it’s above your risk tolerance. It’s really that simple. I cannot tell you how many times I have found myself above my own risk tolerance, had a trade work against me, and then turned back in my direction only to have me get out at breakeven just to get rid of the uncomfortable feeling. Naturally, the trade continues to work out in my favor and I would have cleaned up. The psychological stress can greatly influence how the trade works out.

An exercise for measuring your risk tolerance.

I’ll leave you with a simple exercise. Place a trade with 0.5% total risk on the stop loss. Notice how you feel as you walk away from the computer and let the market do what it will. If it doesn’t bother you, then the next trade should be 0.75%, with the same parameters and the same observations. From there, you simply increase 0.25% every time you place a trade until you find that it’s far too difficult to leave the market alone.

Some people will be comfortable risking insane amounts of money, such as 20%. That’s a completely different conversation as it approaches money management. Money management dictates that you should not be risking that kind of financial hit, but at the end of the day working in a reasonable range in finding where you can leave the trade alone to work out which direction it goes in will be one of the major steps forward to becoming a much more professional trader. For what it’s worth, I have found my risk tolerance to be roughly 1%. Yours may be different, but over the longer-term those types of trades can compound into nice returns.