By Louis H-P on February 13, 2023Reading Time: 4 minutes
A risk model sounds like a complicated math-based process that someone very smart does. Actually it is something which will give you answers to how much you can afford to trade and lose. This in turn will give you the confidence to take risk when others are panicking as you know you can afford to. It will also stop you from taking too much risk and blowing up your account.
What is a risk model
Why you need it
How it can save you money
A risk model is a process where you measure factual information to understand what level of financial risk you are taking. It is useful in helping with any decision making where money is being risked in the pursuit of gain. For traders, many of whom are using leverage, it is particularly useful. Remember risk management should be your focus at all times.
This is because there may be a point where you do not want to risk any more money, as the losses in your trades are so large that you are running out of money to fund them. You could face a situation where you loose everything, something a risk model will help you avoid.
If you are trading spread bets or CFDs, you need a risk model. This is because you are trading with leverage. As a result any gains are magnified (increased) by the leverage you are using. This also means that they are substantially increased if downside risk materialises. Remember 77% of people lose money trading some financial instruments such as CFDs, so you will need every help you can get, such as a risk model.
Firstly you have to figure out how much you can afford to risk. Let’s be clear, we are not saying you should be prepared to lose your money. Anyone who goes out to lose their money, will usually do so very quickly. Focusing on risk, means focusing on staying alive. Anyone can make money, but not many can make money consistently.
Once you have figured how much money (capital) you need to trade with, you can work out some trading rules. These rules will be designed to protect you from having to make tough financial decisions. These tough decisions will involve selling positions at a loss, sometimes a large loss. We have explained three standard rules to follow below.
As most traders are trading on leverage, they cannot afford the volatility if things go really wrong, namely against them. As a result, it is useful to trade different assets. In times of volatility you may find that different assets react differently, so although you will be losing on one, you will be gaining on another.
Another sensible trader will adopt a risk-adjusted approach to trading. A key part of this is to ensure that any risk taken is rewarded with a suitably high return. Therefore exposing yourself to only one asset which may have little volatility for a period of time will mean not being able to make any money. By putting all your eggs in one basket you also risk opportunity loss.
Your account should never be positioned in only one direction, you should always have long and short positions. You cannot stop systematic risk. When it does invariably appear, it will typically be against you. Remember:
The market can stay irrational longer than you can stay solvent
Therefore be prepared to be wrong. Remember your key focus is to stay alive. Profit comes second. Also by being positioned both ways you can benefit whichever way the market moves. You should still be aware that basis risk is still possible though. Nothing ever always goes the way you think it does.
It could you had in mind to trade a particular asset but your risk model show it is too volatile. This may be a bitter pill for you to swallow, as it was this asset you felt comfortable trading and which got you into trading in the first place.
Having said that, be prepared to learn a new asset class, which has less risk but has the opportunity for you to profit. You are trading to make money, not to be right. If you seek to be proven right do not put your money at risk, go and play computer games. Therefore, if the facts tell you something is not worth it, be prepared to accept this and move on.
A risk model can tell you what your maximum risk level is. As a result you will never put yourself in a bad position and then have to sell positions at the wrong time, usually loosing a great deal of money doing so.
Through respecting your risk model, it will provide you a margin of safety. If you can reduce your trading mistakes, you will compound good trades. In turn you will see the value of your account size grow consistently.
It is easy to take too much risk and wipe out your account. Even if your survive, it may take you time, months even to recover what you have lost. You are in effect using your time for nothing. Although this will also be an excellent learning curve, it is a painful one. A risk model will not only increase your profitability but will critically keep you in the game long enough to learn what is required to trade profitably.