In finance and trading, risk tolerance is a measure of how much risk (or loss) an investor or trader is willing to withstand within their portfolio.
Higher net-worth traders are typically able to stomach larger losses than those with a lower income, yet smaller trading accounts are still known to apply higher leverage ratios to increase their potential returns.
Risk tolerance is a very important concept that you need to understand before you place a trade. If you have a trading account with $1,000, are you willing to risk your entire account on a few trades? Can you afford to lose the money in your trading account?
In general, no matter your risk tolerance levels, you should only trade with the money you can afford to lose. That’s why I recommend you take our trading class online for beginners. Not only will you get to understand how to handle risk but also cut your learning curve in half with expert guidance by myself.
Are You Risk-Tolerant or Risk-Averse?
When speaking about risk tolerance, there are usually two groups of traders that come to mind: Risk tolerant and risk-averse traders. The first group of traders is willing to take on higher risks which in turn increases their returns, while the latter group of traders doesn’t want to endure large swings in their trading account.
At this point, it’s important to understand that trading always involves a certain degree of risk. There isn’t a way to take a trade without taking at least a small amount of risk, so if you’re totally risk-averse and don’t want to lose at all, then you’ll have a hard time becoming profitable in the markets.
Trading returns are directly proportionate to the risks you’re willing to take. However, if you take too much risk (by increasing your leverage, for example), the possibility of blowing up your account increases as well.
Risk isn’t something that traders need to be afraid of. Without risk, there wouldn’t be any trading opportunities in the market. However, without a proper way to control your risk, you’ll likely find yourself in serious trouble after a losing streak.
Take a look at the following table for example. The table shows how much profits you need to make to return to breakeven after you lose a certain percentage of your capital.
|Amount of Balance Lost||Amount Necessary to Return to Initial Balance|
Let’s say you’re risking 10% of your trading account on any single trade and face a losing streak of 5 consecutive trades. In this case, your balance would fall by 50%, which would require a return of a whopping 100% just to return to your break-even point! This example highlights again the importance of sound risk management rules in trading.
A risk-tolerant trader needs to have a deep understanding of the key market drivers to exploit maximum returns with maximum risk. If you’re a beginner or just getting started with trading, you should keep a close eye on your risk levels and never risk more than 1% of your trading account on any single trade. We’ll discuss this in more detail further below.
Extremely risk-averse traders will have a hard time to extract profits on an intraday or very short-term basis. Instead, risk-averse traders tend to have a buy-and-hold approach which is more similar to investing and would purchase non-volatile and highly-liquid securities such as certificates of deposits or US Treasuries.
What Trading Style to Choose?
Depending on your risk tolerance, some trading styles are more suited for risk-tolerant traders, while others work better with risk-averse traders.
- Scalping: Scalping is a very short-term trading style that involves taking dozens of trades on an intraday basis. Scalpers hold their trades for a very short time, sometimes even for seconds, and aim to make a small profit on each trade. Scalping should only be used by risk-tolerant traders, as the high frequency of trades requires a good understanding of markets and risk management.
- Swing trading: In swing trading, trades are held for days or weeks in order to take advantage of market swings, such as impulsive and corrective moves. This trading style can be used by both risk-averse and risk-tolerant traders, as it can offer attractive reward-to-risk ratios and fine-tuned entry points that reduce the overall risk level.
- Position trading / investing: Position trading and investing involves holding trades for months or even years. Position traders aim to exploit market inefficiencies over the long-term and need to be able to withstand larger price-movements over the holding period.
While this means that position traders have to be well-capitalized, you’ll find both risk-averse and risk-tolerant traders using this trading style.
How to Manage Risk?
No matter your risk tolerance, each trader needs to control his risk levels and follow a strict trading plan. However, risk-averse traders will likely spend more time on controlling and fine-tuning their risk levels than risk-tolerant traders. Follow these key rules before placing your next trade on the market:
- Risk-per-trade: This is a measure of your total risk per any single trade. Risk-averse traders tend to have a lower risk-per-trade, while risk-tolerant traders are comfortable with taking a higher risk per trade. Risk-per-trade is usually expressed in percentage terms of your total trading account. For example, a risk-per-trade of 2% means that you’re risking 2% of your account on a trade.
- Reward-to-risk ratio: The R/R ratio refers to the ratio between a trade’s potential profits and potential losses. For example, an R/R ratio of 1 means that you’re risking $1 to make $1, while an R/R ratio of 3 means that you’re risking $1 to make $3. Intuitively, the higher your trade’s R/R ratio, the less risk you’re taking to make a profit.
- Risk-averse traders: Tend to take trades with higher R/R ratios, as it allows them to stay inside a trade for a longer period of time and make a decent profit even with a lower leverage ratio. On the other hand, risk-tolerant traders are also happy with a lower R/R ratio, as they can take advantage of leverage to magnify their potential profits.
Questions to Ask Yourself
To recap: Risk-tolerant traders are willing to take on higher risk in return for higher profits. You’ll find many risk-tolerant traders to be scalpers and day traders, trading equities, CFDs, and options on a short-term basis.
A risk-averse trader is a trader who prefers lower returns with lower and known risks. S/he avoids risky investments and is willing to sacrifice parts of the profits to lower his/her risk. Risk-averse traders prefer safe investments, such as government bonds or longer-term position trading with a buy-and-hold strategy.
Risk tolerance often varies based upon age, net worth, experience, investment objective, and other factors. Younger traders usually tend to be more risk-tolerant than older traders who trade and invest for their retirement, for example. Also, higher net-worth individuals are willing to take on higher risks compared to traders with a smaller capital base.
Here’re some questions you should ask yourself to check whether you’re tolerant or averse towards risk:
- What’s your trading goal? Do you want to grow your capital rapidly and are willing to take more risks to achieve your goals? Or is capital preservation your main goal?
- What’s your trading experience? The more experience you have in the markets, the more risk-tolerant you’re going to be. Also, experienced traders have a strict and systematic approach to risk management, which allows them to keep track of their risks at any time.
- Is the risk worth taking? Let’s say you’ve identified an attractive trading opportunity in the markets, with a potential reward-to-risk ratio of 2:1, i.e. you’re risking $1 to possibly make $2. Ask yourself whether you’re able to stomach the loss in case the trade goes against you. If not, reduce your risk or look for trade setups with a higher reward-to-risk ratio.
- Evaluate your performance: Are you happy with your trading outcomes? How do you feel when your trades return a loss? Do you consider losses as a part of the game, or do you want to avoid them at any cost?
Risk-tolerant traders accept the fact that losses and risks are a part of trading. Each strategy will have periods when it won’t perform, but when it does, the higher returns more than offset the losses.
Risk tolerance measures how much risk a trader is able to stomach within his or her portfolio. Risk-tolerant traders are willing to take on higher risks in return for maximum returns, while risk-averse traders avoid risk, even if that means missing out on higher returns.
There are many factors that influence the risk tolerance of individual traders, such as age, market experience, net worth, and investment goals, to name a few. It’s crucial for a trader to assess his risk tolerance early in his trading career, as many of his trading decisions will be directly impacted by how much risk he’s willing to take.
Credit: My Trading Skills