Fear and risk

 

I hope this message finds you safe and well, and that your lockdown has been tolerable. For those still shielding, I hope you’re bearing up.

Lockdown at Trader’s Bulletin Towers has been uneventful – which is about the best you can hope for.

For me, going into lockdown was very straightforward – I already worked from home (it just got noisier). It’s the coming out of it that’s much more tricky and nuanced, with lots of decisions to make and risks to be balanced. With teenagers in the house, they are desperate to get out and socialize – again it’s finding some happy medium between locking them up in a tower, and letting them go to a rave.

As I’ve often discussed here, human beings are notoriously bad at judging risk.

Whether we’re deciding to gamble all our winnings on the last round of a game show … (Otherwise known as the “I came with nothing, so I’ve lost nothing” argument.) … or we’re hovering our fingers over the button to close a trade …

… relying on gut instinct to tell you what’s right is unlikely the smart option.

Too often our risk evaluations run along the lines of … ‘hey, what’s the worst that could happen’ … or ‘other people are doing it, so it must be okay’ … then we close our eyes and jump in.

One of the problems we have with risk is that it’s often not even about a balance with potential rewards. Risky behaviour can be the reward in itself – taking risks can be fun.

Risk can make us behave in strange, irrational ways, because we get a kick out of it. We like to test our nerve, scare ourselves and get the adrenalin pumping, whether it’s riding roller coasters or taking Forex trades.

Needless to say, these are some dangerous impulses that we, as traders, really need to get a handle on!

The best way to do that is to base our behaviour on facts and data.

The good news is that we should be able to do that very easily.

That’s a great thing about trading risk – it’s very easy to quantify.

We can predetermine our risk before we even dip our toes into the market. If we know where our stop level is, and what our stake is – we have the exact number for our risk. (If you use guaranteed stops, you can even eliminate the risk of slippage.)

So, if we’re trading with a £2 stake and our stop loss is 50 pips away, the we know we’re risking £100 on that trade.

More tricky to quantify is the risk of drawdowns, when multiple losing trades pile up on each other. However, if you’ve tested your strategy properly, you should know its success rate – which means that you can calculate the risk of drawdowns …

There’s an easy way to calculate this.

If you want to know the probability of getting, say, 5 losing trades in a row, it’s just your losing rate to the power of 5.

So, if you expect to lose 45% of your trades, then the probability of taking 5 losses in a row, is: (0.45)^5

= 1.85%

So, there we have it – risk has been tamed.

We know what risks we’re taking with our trades.

Of course, the nature of uneven returns means that losing runs don’t space themselves out neatly, and your worst losing run will always be ahead of you (as will your best winning run!) – but we’ve looked our risk in the eye. We know our opponent.

It’s then up to us to keep our risk small and manageable, so we’re not getting sleepless nights.

Risk gets a lot of bad press, but it’s really not the villain it’s made out to be. It’s about unpredictability of individual outcomes – the element of risk is the same thing that brings us winners and losers. Without risk, there would be no money to be made from the markets.

Trading losses aren’t about errors (okay, sometimes they are – but mostly they are because we can’t predict individual outcomes). When we realise this, we find trading a much more relaxing and rewarding process.

 

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