Risk Management and its Fundamental Importance

Risk management is one of the most vital elements of trading the financial markets. Are you giving it enough attention?

Risk Management

Risk Management – along with other elements – is one of the important horsemen of the trading realm. As such, you can be wrong half of the time but still make a fortune thanks to successful risk management. On the same note, you could damage your trading account if you aren’t careful with the way you are diversifying your risks.

The most important factors here are understanding your risk appetite and comprehending the logic behind the notion of risk-reward.

Appetite for Risk

Defining risk tolerance and exposing only a small proportion of total capital per trade is crucial for consistency and profitability in the long term. For instance, we risk no more than 1% of our capital per trade. We have been doing this since the beginning and plan to keep it consistent indefinitely.

As an example, consider the ‘egg’ analogy. Imagine you have a basket of 100 eggs (each egg representing 1% of your total capital). By exposing only 1% of your total equity on a trade entry, you will break only one egg if things go south. However, if you risk around 5% or 10% per transaction, it means putting a big chunk of your eggs in one basket and risking significant damage. The former approach is long-term sustainable, while the latter is detrimental.

Win Rate < Risk-Reward

Many beginners focus on having a high win rate. However, as we have emphasised earlier, you do not need to be right all the time to make money consistently in the market. In fact, trading is a decision-making game. We make decisions that turn out to be successful and others that turn out to be unsuccessful. The main logic here is to achieve more successful decisions than unsuccessful ones in the long run.

To support this idea, let’s look at the illustration attached below. As can be inferred, by risking 1% of total capital per trade, with an average 1:3 risk-reward ratio and a win rate of 40%, it is possible to generate a return of +4% by executing only eight trades.

The importance of prioritising ‘risk-reward’ over the notion of ‘win rate’.

To bring a live-market example, let us demonstrate what took place in November of 2023 within the Investroy Academy. Out of five trade positions executed during the month, only one transaction yielded in profits. Due to the fact that the risk management plan was abided by – losses were minimalistic and the winner was fruitful – with a win rate of 20% only, we were able to generate a net return of +2.8%. This, once again, proves the crucial nature of risk-reward and its superiority over the notion of ‘win rate’.

Conclusion – Author’s Recommendation

There will be times when your heart desires to risk more than what is admissible. In such situations, bear in mind that the factor of greed is taking control over you.

Be consistent with your planning and adhere to its rules. If you need to make optimisations, go ahead and do so. However, always remember that the road to success and profitability in the long run passes through the doors of consistent risk management.

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