What Is Your Risk Tolerance?

Philippine-stock-market-boardThis is a subject most traders do not pay attention to. Hence the failure rate in this business is one of the highest compared to other businesses including offline ventures. So what is your risk tolerance? If you don’t know the answer to that, perhaps you should stop trading right now and find the answer to that question immediately, as it will hold the key for your long-term success in trading.

Probability of winning or the win rate

I started with this subheading because this is the only thing most traders focus on when it comes to choosing the right strategy. In trading, high win rate doesn’t always mean higher profits. But that’s a different topic altogether. The win rate however holds an important information that relates to risk tolerance. If you know the win rate of your strategy, that means you know the loss rate as well. If you have an X% as the win rate, obviously your loss rate is (100-X)%. Lets number this as Y (=100-X.)

Now you have a number, for example in 100 trades you can expect to win around X number of trades and lose Y number of trades. If you consider 100 trades is a good sample size to plan your trading for, can you afford to lose the first Y number of trades and still be in the game to win the other X number of trades?

I know its an extreme distribution of the win rate. But if you plan for the worst, then you can survive the bad, right? What does losing Y number of trades mean in terms of pips and capital? If you can afford lose this amount of the account and still be confident to place the next trade, then your risk tolerance is in good shape.

Important thing you have to understand is that the win rate or the loss rate is NOT distributed equally. This has nothing to do with the strategy or the market conditions. Even if you have a strategy backtested for at least 2 years worth of data, which eliminates (to a considerable extent) the unpredictability factor of the strategy, you must prepare for streaks of losses as well as wins.

Streak of Losing Trades

Anyone who has been trading for long enough has the experience of a losing streak. If you don’t expect a forthcoming loss, or you feel devastated when it happens then, you have to work on your risk tolerance and understand the probabilities attached to trading.

Although a losing streak in terms of total pips and capital is more depressing, the number of losses too is an important factor to account for. That is the only positive integer in a losing streak. I know what you are thinking. How come the number of losses in a row mean anything positive, right? The higher the number of losses, the higher probability it has for the next trade to be a winner, that is if you are methodical and follow your tested strategy religiously.

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Numbers don’t lie, and sometimes you need to consider a larger sample size of trades to have a positive expectancy for a strategy. That’s why you need to have a good understanding of how much risk you can tolerate, and device a strategy to comfortably accommodate that amount of risk.

Understanding the Equity Curve

I assume that you have tested your strategy well enough, that on backtest results it shows a good return over a considerable period of time. The equity curve is the most important indicator  to look at when you analyze a trading journal, because the growth of balance and the win percentage means nothing if the equity is in a decline.

Equity = Balance + Floating Profit/Loss

While analyzing your backtest results had you located the longest period where the equity curve was in a decline.

At this point perhaps you might be wondering if this was the most ridiculously negative post about trading, because all I’m talking about today is risk, losses, drawdown and declines.

Let me put it this way. When I first started trading, I was the most optimistic trader you could ever find, but not anymore. I learnt the hard way, that to make money in forex is to preserve capital and manage risk. Even if you believe this post to be on the negative side, trust me you will soon find this to be more valuable than any positive article about foex, which you can easily find on the internet.

Back to the subject, analyze an equity curve of a trader who is perceived to be successful and has quite a name on the business. It could be anyone, who trades forex as a full time profession. You will be amazed at how difficult it is to find a single trader who hasn’t had a negative month, given that he has been an active trader for several years. If you find anyone, please share his name in the comments section. I will be eager to learn from him.

forex-trendy-reviewMy point is that, when drawdown occurs there is another dimension of it that badly hurts – the time factor. See, not only you loose pips and money, but also invaluable time spent trading those losing trades. So study and understand your equity curve (if you’re just starting, study your backtest or forward demo test journals,) and be prepared to tolerate those periods of drawdown as well.

This too is a part of risk tolerance, because its all about how you can handle the situation when things start going the other way.

Sample size

If you are reading this far, you should have noticed that I mentioned sample size several times. Because its an important yardstick to determine at least a ballpark range as risk tolerance. The higher the sample size in question, more realistic your expectations gonna be.

Lets take the same example – the sample size of 100 trades. In 100 trades if your win rate is 60%, you can assume to have the same 60% win rate for the next 100 trades, right? Wrong, win rate varies according to your sample size. Variation of the win rate and the sample size in question has a reverse correlation. If the sample size is too small, then the ‘variation’ of the win rate is obviously high, and vice versa.

This is why its important to run backtests and forward demo tests on strategies for longer periods. As a rule of thumb I personally run backtests for a minimum of 2 years. Then even if the forward tests last for only a few months, as long as the average results match with the backtest, strategy is considered to have a positive expectancy.

In terms of the number of trades, 1000 trades is a good sample size for day trading strategies. If you can do the math on a trade journal which has a minimum of 1000 trades and realistically define a certain percentage of the account capital as your risk tolerance, I think you have a long term winning formula. Not only you will have confidence in the strategy to place the next trade even in the middle of a losing streak, but also the expectancy of the strategy is based on a convincing sample size.

The higher the sample size you use on your testing, the better chances it will include the best as well as the worst possible scenarios. Imagine a simple event like tossing a coin up. Assuming the coin is evenly balanced, either side of the coin has an equal 50% probability of landing face-up. But if you repeat the process for long enough, for hours and hours, thousands of times and more, you now have a presumably a huge sample size.

Assuming that you have recorded the sequence of results, you will inevitably find long streaks of ‘heads’ as well as ‘tails’ flipping face-up. Similar variation of distribution occurs in trading as well. As they call it, its a numbers game.

Drawdown of a Single Trade

If newbie traders are concerned about any sort of drawdown at all, its only how much drawdown they see on a trade by trade basis. Even then, more often than not, they are emotionally involved in the trade while price fluctuates moving the floating equity back and forth. This is often a sign of overtrading, using leverage beyond their capacity or minimal risk tolerance. Or a combination of all three reasons.

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While handling equity drawdown throughout a period of time is more important in the longer term context, handling drawdown situations on each trade is a minor fractal of the same scenario. In case you are wondering, its actually a part of risk tolerance.

The cure

Since handling drawdown of each trade is a closer view of a potentially larger issue, its a good place to start rectifying the problem too. A good method to follow is to think of it objectively and if placing a trade creates a guilty feeling or adds pressure on you psychologically, stop right then and go to the basics – follow the strategy. Because if you get a guilty feeling about placing a trade, chances are the trade is in contradiction to your own strategy and its rules of engagement.

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If you haven’t already, go and backtest your strategy for the last couple of years data. If you have been trading live for the past couple of years, this will help you determine how disciplined your trading was during that period. This exercise will not only boost your confidence, but also gauge the relative and maximal drawdown. So you can compare the positive and negative expectancy of the strategy, against your level of risk tolerance.

Consecutive wins and losses on the backtest report is another indicator to latch onto and expect similar results on live trading as well. Usually a strategy with high win rate will have higher number of average/maximal consecutive wins as opposed to consecutive losses and vice versa. The tricky part is if this number varies too much on live trading, understand that past results is not always a guarantee of the future results. Just stick to the strategy and always keep the overall risk tolerance in check.

Other useful trade-journal-analysis include MFE (Maximum Favorable Excursion) and MAE (Maximum Adverse Excursion.) Although they deserve another post altogether in order to explain them completely, with the scope of risk tolerance in mind, its sufficient to understand that MFE plots in detail – how far a trade goes in reverse direction before it comes back into profit (scaled against time) and MAE the opposite. This is very valuable information to define optimal stoploss and takeprofit levels (if you are using fixed SL and TP in your strategy.) Likewise in terms of risk tolerance it gives immense insight into probable price ranges that typical trades tend to fluctuate between.

The cure for not knowing your level of risk tolerance is to know it. Simple as that. Ask yourself the basic questions, at what point do you feel uncomfortable? If you hold onto open positions overnight quite often, how much of an equity drawdown can you handle and still have a good nights sleep? How many open trades at a time should you have and what is the maximum number of trades can you handle?

Every point discussed in this post deserves a self-evaluating question and a clear cut answer to go with it, if you are really serious about continuing in this career path as a professional trader. Learning and understanding your comfort zone is the only cure for complications of ‘not-knowing your risk tolerance.’

Conclusion

Let me emphasize the reason – why you should pay so much attention to your risk tolerance? How often do you come across experienced traders who speak about psychology and discipline being a major part in their trading-success. Well, how many of them had taught you how to achieve that peace of mind and that sort of discipline while trading. Well there you have it.

Make sure you put all of the discussed tips and advice to good use. You are most welcome to discuss your experience, any comments and questions you may have, in the comments section.

There is no escape from psychological and disciplinary challenges unless you understand the bigger picture behind those issues. Understanding your risk tolerance is just a small step in the right direction for trading success.

 

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