Risk and the Trading Game

Every time you initiate a trade you start a new game in which you assume all risks for playing the game. By choosing to be an active share trader (or forex or CFD trader) you are seeking risk for a larger return on your cash. One of the most important elements of your trading game is managing risk. Smart traders are always on the lookout to reduce their trading risk and watching the risk currently in play on their trades.

Risk is inevitable in the share trading game. In order to gain a profit, you must risk. The larger the risk you choose to take the larger the potential gain (or loss). But you must also be wise enough to choose the smart risks over dumb risks. What do I mean? Professional poker players may see their sport as a smart risk – they can engage the game knowing the probabilities of a win in their hand and they could possibly win via tells or reading how their opponents play. Personally, a lottery is a dumb risk, since the chance of winning is astronomical, and there is nothing you can do to maximise your chances of winning.

So how do you maximise your chances of winning in the trading game and minimising your risk profile? You may already know the answers: you must read up on fundamental analysis, technical analysis, the financial news related to the markets you are trading and have money management rules in place. Or course you also need the all important trading strategy written up, back tested and followed with thorough discipline.

Risk Money Management Principles

Imagine that you are playing in a TV game show – each trade you take is a challenge put to you by the host. Your most recent trade was profitable and delivered a profit to you of $1000. In a typical TV show the host would probably offer you the $1000, or you can play again for double (or nothing). Since you’re an active share trader, you have no choice but to keep playing this game in an endless loop. And it isn’t wise to play the trading game double or nothing. You could try, but the odds are stacked up against you. So this is where smart risk money management principles come into play.

Let’s say our theoretical trading account begins at $10,000. Our trading system delivers us either a $1000 win or a $500 loss on average each time it is executed. Executed once we win $1000, another, loss of $500, another, win of $1000, then win of $1000 and another win of $1000. Of course this is a perfect example and your results may vary according to your own personal trading system. The point is that it is important to make sure, via backtesting or other means, that your system is delivering the results you want. Also, a winning or losing streak in the short term may not be indicative of the longer term results for your trading system – so it is important to know what market conditions are well-suited to your trading system.

There is an economic principle called the law of large numbers which is a statement about the phenomena when a game (i,e. your trading game) can be repeated over and over again – since a game played many multiple times, the elements of good and bad luck are eliminated. The same principle is used by insurance companies in spreading their risk (imagine each insurance policy holder as a "game"). So here’s another angle to think about risk and your trading game. Should you focus on the quantity of your trades and trade more, or focus on the quality of your trading and trade less, concentrating on a handful of successful trades?