Trading is, by definition, a risk business. Someone – either a live person or a company – is on the other side of each trade, and the risks in trading are that they are right and you are wrong.
Those who disapprove of financial trading, for whatever reason, may try to persuade the would-be trader that their funds would be safer tucked away in long-term investments. The trouble is, investment is a risk business as well.
Why is someone trying to sell you stocks or bonds? Because they believe your money is worth more to them now than these securities would be over time. Most so-called investment is actually a form of trading, albeit in slow motion.
Risk should be welcomed
You may here talk of the “risk-free return”, essentially the return on bank deposits and government bonds. But while bank deposits are insured and developed-world states don’t tend to default on their debts, even here there is risk, such as that inflation will erode the value of your assets.
Early on, would-be traders will be advised to decide how much risk they are willing to assume and to proceed from there. But there are two big questions - how do they measure risk and how do they then decide how much is enough? There is, of course, a third question regarding trade risk management – the limiting of the trader’s exposure to risk.
More on that in a moment.
First, the measurement of risk. In classic trading theory, this is calculated using a risk/reward ratio, comparing likely gains with likely losses. An obvious objection to this form of risk analysis is that anyone knowing the precise loss or profit on a deal would be enormously rich at the expense of all the other traders.
But the risk/reward ratio is not about certainty but about probability ,a subject that has long fascinated market players including the great economist John Maynard Keynes. The question of how to measure risk is answered by the assessment of the relative probabilities of a trade producing profit or loss.
Historical data is key
There is nothing to stop a talented trader, or one who believes they have a gift for clairvoyance, from simply guessing that a certain trade has, for example, a likelihood of returning £1,000 profit against a likelihood of £100 loss. This would produce a very favourable risk/reward ratio of 1 to 10.
However, most traders, certainly those just starting out, would probably prefer to trust something more than intuition before deciding to embark on this supposed sure-fire winner. In most cases, they will rely on historical price data to calculate the risks in trading – and the potential rewards.
More favourable would be a loss risk of £100 and potential profit of £300, a risk/reward ratio of 1 to 3. But a risk analysis that produced potential losses of £300 and profit potential of £100 would give a distinctly unfavourable 3 to 1 risk/reward ratio.
Past performance is, of course, no guarantee of future returns (or losses). But to repeat, risk analysis is a matter of probability, not a guarantee. A trader will, inevitably, be on the losing side of some trades. What matters is their ability to hone their skills in terms of studying historic information and of making accurate judgments of the risk/reward ratio in each case.
Which takes us to the second big question – how much risk is right for each trader? It would be easy to simply declare that this is an entirely personal matter and will differ from one trader to another, and that is true to a certain extent.
There are, however, some key principles to be applied in this area when drawing up a trading strategy. An obvious one is to ask how much the trader can afford to lose. A small sum does not necessarily dictate a lower-risk strategy, but taking bigger risks increases the chances of losing all their stake money.
Limiting risk exposure
Another principle would be to ask how experienced is the trader. Broadly speaking, the greater the experience, the higher the risks that can be assumed, because calculations of such risk are necessarily averages and include everyone in the market, including those less experienced.
One straightforward step is to take out a stop-loss order on each trade. This could be simply set at the level of loss calculated in the risk/reward ratio, or it could be a moving stop-loss order that will trigger a sale when the asset falls by a certain percentage point from the highest level reached during the trade.
This latter option has the beneficial effect of protecting any gains as well as shielding against excessive losses. A second type of order would trigger a sale when a pre-set profit point has been achieved, perhaps the level of gain calculated by the risk/reward ratio.
Such an order would guard against the profit-threatening hazard of trader greed!
Finally, trading risk management relies on a methodical approach to trading. Plan in advance which trades are to be undertaken, what the profit targets and stop-loss levels are, and then follow that plan.
There may be a place for spur-of-the-moment impulse trading, but not as regards novice traders who are new to the market.
Risk-free trading is a contradiction in terms. Risk is there to be measured and managed, not avoided.