One of the most important parts of any trading system is the ability to survive losses. The reality is no matter how good of a trader you are, there will be times when you take a couple losses in a row. This is just a simple fact of life when trading.
The successful trader will have a defined risk tolerance and will stick to it. If the system that you are using has a well-defined risk component, it helps smooth out the equity curve as well as the emotional roller coaster that can come with trading. Also, if you are not willing to stick to your defined risk tolerance, you may find that a couple losing trades may evaporate more of your account than you are willing to part with.
Once your risk tolerance is established, it becomes a vital part of your system, helping with fear and greed. Let’s say that your risk tolerance is 1.5% on each trade. It becomes much easier for you to place trades when you get signals to, as you have established what you are comfortable with risking.
Of course, you have to know how to find what your risk tolerance is. Theories abound on what you should base the amount your risk on each trade, but the truth is it will be different for each one of us. The most important aspect of risk tolerance is found in your psychology. While math certainly can come into play when involving the selection of trade size, if you are not comfortable psychologically in which you are risking, you just won’t execute the trades well.
One of the most common ways a trader sabotages themselves due to a lack of defined risk tolerance is exiting a trade far too early. If you find that you are exiting long before you get a signal to, there is a really good chance that you are very income for with the amount you are risking. Perhaps it would make sense to cut your position size down slightly. This is a little bit of a trial and error situation, as what you are comfortable with will vary drastically from what other people are willing to risk. However, if you pay attention to your reaction on each trade, you will eventually find that “magic number”.
Because of this it is very important to pay attention to your psychological state of mind every time you enter a trade. If you find that you are becoming increasingly tense, you simply are trading with too large of a position. Conversely, you may find that you are extremely comfortable and that the returns are too little to justify the effort. Needless to say, this is a signal to increase the risk amount.
Once you find the proper risk tolerance for your personal psychology, you will find that placing a trade becomes an almost automatic event as you can do it without hesitation. Although defining your risk tolerance isn’t one of the more exciting aspects of trading, you will find that it is without a doubt one of the most important. Being confident in your trading ability allows you to make quick, concise, and most importantly, clear decisions when it comes to placing a trade.