Interestingly, the uninitiated often think of risk as the total dollar amount of the position at initiation (in the case of Stock A above, $10*the number of shares purchased or 25,304 in the case of the YM).
While this is true in the abstract sense, as a practical matter this is only true if one allows a position to go to zero rather than recognizing a loss at some earlier point (like the $8/25,258 levels suggested in the examples). If one allows this to happen, the words of Gordon Gekko seem particularly appropriate… “A fool and his money are lucky enough to get together in the first place.”
But what is this probability based exposure? The concept is really quite simple. Traders should put on the largest positions when the probability of substantial loss is lowest.
That is, the larger your stop loss (the distance your stop is from entry), the smaller your allowed position size. Most people (especially new traders) focus on trading the most when they think the possibility of success is highest.
This ignores the importance and realities of risk and presents the exact antithesis of what’s needed as traders should always make it their business to have the smallest positions when the size of the potential loss is largest.
To remedy this, amateur or unprofitable traders (no, they’re not always 1 and the same) spend their time searching for trades with a near 100% probability of winning… commonly known as the Holy Grail.
Unfortunately, the only 100% probability setup is to avoid trading at all. The downside of that approach is it also happens to deliver an equivalent return. It risks the least (0), but also rewards the least (0).
Successful trading is about finding the sweet spot where you risk the least for the largest reward. In other words your search must be for asymmetric outcomes (a little risked on a relative basis with a possibility of an outsized return)… in your favor.
Understanding risk and its place in your trading is a central key to your trading success.
I cannot overstate this.
I hate the use (overuse) of exclamation points in writing, so consider this my version of yelling, stomping and jumping up and down… UNDERSTANDING RISK AND USING IT APPROPRIATELY WILL DETERMINE YOUR SUCCESS…PERIOD.
UNDERSTANDING RISK AND USING IT APPROPRIATELY WILL DETERMINE YOUR SUCCESS…PERIOD.
Understanding how to minimize and manage my risk was the proverbial corner I had to round in my own trading journey. Long ago I learned that lesson and to structure my trading to expose the least amount of capital to loss at all times. Then, within the context of this minimizing, to use my risk exposure to reflect my personal sense of the relative probabilities of different trading opportunities and outcomes.
It's worked well.
This is the backbone of how I trade as well as how I guide traders to interact with the market. If you make it a core part of your trading, it will improve your profitability… enormously.
