When we learn about risk in trading, it tends to be packaged up neatly in the same box, with the same information, regardless of the source.  After years “behind the screens”, I am constantly revisiting what risk really means in trading.  There are many facets that stem from this single word.  Today I thought of an example which hopefully will make you stop and think about the way you look at risk, hence “The Trading Risk Conundrum.”  But before we get to that, let’s discuss possible definitions of that dubious word when it comes to trading.

1)  Risk:  A Broad Definition:  Risk in one way means that this is a capital outlay that has the potential to be lost.  The old adage “nothing ventured, noting gained.”  Here the euphemism “ventured” really means “risked”.  This applies so broadly in business it becomes an assumption.  Even “you gotta spend money to make money” really means there cannot be gain without something risked in the first place.  From poker playing to opening a bakery, “risk” really means a capital outlay that there is at least some chance of losing in the pursuit to make something in return.

2)  Risk (Spectrum):  This takes the first definition and now ads a variable aspect to assign a particular value to risk along a sliding scale depending on HOW much chance there is from 0-100% that the capital outlay will be lost in the transaction/venture/trade.  This is the most commonly used meaning for the term in financial trading.  Everyone wants to know what their chances are of losing any given trade/transaction.  In general terms “HOW” risky a trade is based on the trade itself.  What chance will it win?

3)  Risk Appetite:  This refers to how willing the trader is to participate in a trade based on how “risky” it is using the last definition.  Keep in mind that NONE of these definitions take into account the potential reward.  Obviously the standard thinking is that a “riskier” trade should yield a higher reward and a trader with a bigger “risk appetite” would be seeking bigger gains for that risk.  This view can be found in virtually every economic textbook to boot.

So now comes the conundrum.  Let’s say we have two machines:  The first machine spits out $3 EVERY OTHER time you insert $1 into it.  The times in between it returns nothing.  The second machine spits out $100 every 20th time you place $1 into it, and the other 19 times, it returns nothing.  Which machine would you rather own??? The first machine returns much more regular gains, albeit a small amount, while the second machine returns very big returns, but there are many more transactions in between those returns.  Both are profitable, and it would be hard to argue that the first is more profitable since the gains the second produces are 5:1 versus 3:2.   But, which one is riskier???  Regardless of your answer, you’d be wrong.  Why??  Because it’s actually a trick question with one VITAL part of information missing.  Confused??

Let me add the missing piece of the puzzle, THEN answer again.  Let’s say you get the machines, and you have $5 ONLY to use.  If you can’t produce a profit, you lose the machines.  You have no idea which part of the “cycle” either machine is on.  Now which one is riskier???

As an alternative, let’s say you have $50 instead.  Still want to take the first machine??  Did the machines change??  No, all that changed was your position in the situation.  But it has a dramatic impact on how “risky” each machine is.

Risk in trading has multiple variables, but we often overlook our accounts as one of them.  We spend so much time focusing on the R/R (reward risk) and everyone tells you “higher R/R is better”.  While this may be true if you can actually achieve the sample size necessary to cash in.  Something that wins less often can actually be more profitable than a strategy that wins more frequently for less, IF you can withstand the necessary “losing period” in between bigger gains.  And people so wrapped up in a high win % might be missing out on bigger gains overall by trading a bigger R/R approach for the psychologically comforting consistent win rate.

The message here is you must look at the bigger picture.  The overall goal of trading is profits, and bigger is better…….so long as you don’t risk blowing up the account along the way.  Don’t be afraid to lose a few in a row if the eventual outcome is a huge win that dwarfs those little, numerous losses along the way, but don’t risk all your capital to do so.  And don’t settle for a small R/R just to make sure you are not having to deal with the psychological stress of multiple losses.  On the same hand, don’t always “swing for the fences” when consistent profits are there for the taking.  You see, one approach is only riskier if you cannot afford to do it, and that’s why it’s easier to make money when you have more and why banks can hold their positions longer for gains and smaller traders must use much smaller stops to be more precise to keep the lot size up.  In the end, we must view trading risk as a complete machine, with many variables which must be carefully monitored and adjusted based on the situation.

To be a good trader, you must examine your own trading risk conundrum and create a plan that puts you in the profitable and consistent column.

By Omar Eltoukhy

GOLDTRADEMASTER.COM

Trading Risk