By Louis H-P on November 14, 2018Reading Time: 3 minutes
Have you considered selecting trades for their potential risk rather than their prospective profit? This approach may sound counter-intuitive but a risk management plan should be at the forefront of all traders’ minds. A risk-based approach is where risk management dictates how trades are selected. After all, It is hard to make money if you are losing it all first! Keeping hold of your money is something Warren Buffet lives by.
A risk-based approach requires a trader to identify, assess and understand the risk to which they are exposing themselves to. In effect you are looking to minimise risk in each trade. As opposed to focusing uniquely on profit. This requires learning to take the appropriate steps to reduce risk to an acceptable level. Diversification is a perfect example! Taking positions which are only 2% of your portfolio is advisable. If the trade goes wrong, you have only lost a small fraction of your total portfolio. There are also practical implications of a risk management approach. With multiple threats to your trading profits it is useful to keep a critical eye. Your future profitability as a trader will depend on your ability to manage risk. A successful risk management process will reduce losses to a small and affordable total amount. This will ensure profitable trading!
In any risk-based approach, you will need to identify the key risks to your trading strategy. This could involve:
Once key risks have been identified, any aspiring trader will need to develop risk mitigation skills. These will involve soft skills such as controlling your emotions and having a disciplined approach to trading. Emotions can be troublesome as you allow outside events to cloud your judgment. Discipline ensures that outside events, such as emotions do not negatively influence your decision-making ability.
Any risk-based approach means keeping things simple. The more complex a trading strategy the bigger the risk of something going wrong. You need to decide if more complicated trades are worth the potential profit and risk involved. As a rule, less is more!
How can you learn from your mistakes if you don’t recognise and record them? Learning which risks cause the biggest losses will help you mitigate future risk. This approach will ensure you learn to take small risks which in turn produces regular profit.
The meaning of a risk-based approach also consists of knowing which trades to prioritise. This applies to a trading opportunity which may be different from your strategy. A trade with a smaller return, is often more worthwhile than a new kind of trade which promises larger returns. It is best to focus on learning to trade one type of security perfectly, than several imperfectly.
As part of a risk-based approach to trading you will have identified key risks to your trading strategy. The more you trade, the more you will learn about the weaknesses in your strategy. This will highlight new risks which will need to be assessed. Learning to monitor these new risks will allow you to strengthen your risk-based approach.
Risk mitigation planning is not something you should expect someone else to do. You must do it yourself. If you do not know the risk you are taking you cannot mitigate it. In a risk-based approach you should be just as excited by finding and reducing a risk, as you are finding a profitable trading opportunity.
The primary advantage of a risk-based approach is to steer traders towards good trades and away from bad ones. Good trades are profitable with only a small amount of risk taken. Bad trades create huge losses where the profit was insufficient for the risk taken. Too many traders pursue profits without realising the downside. A risk-based approach is a state of mind – it means you will see the risk first and the opportunity second – ensuring success!