Thursday Trader's Tip: Risk Tolerance
Welcome to Thursday Trader's Tip — the free edition of The High-Performing Trader newsletter. Each edition presents to-the-point trading psychology advice in video and text.
This week's episode is about risk tolerance.
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Transcript:
When we think about risk tolerance, we think of different people and traders who have different levels of risk appetite.
On one side, we have the risk-averse traders who might use 0.5 to 1% exposure on their trades, and they have a tough time enduring losing streaks and, you know, losses.
Then we have, on the other side of the spectrum, the more risk-seeking traders, and these traders are the ones who don't have any type of problem in pressing when the conditions are favorable to their edge, let's say, on their A-plus setups. They understand their edge; they know what are the setups that give them better statistics - better win rate - and when they show up in the market, they have no hesitation, both to take the trade and to go in with a bigger size, and perhaps even pyramiding in the duration of the trade, while it's going in their favor. So, these are two different types of traders, and their trading performances are quite different.
So, for example, risk-averse traders are incapable of pressuring harder, even if they realize that the A plus setup is there, but they just cannot click the button, they cannot take action, they hesitate, and they second-guess their confluences. And so they have this difficulty acting on the reality of their strategy and of the market. Now, when it comes to risk-seeking traders because they take more risks, they naturally also have better and bigger rewards - normally, it's like this.
An important mindset shift to achieve here is the one that even if you don't take any risk, even if you remain in your comfort zone forever, this still has a risk involved - the risk of not growing, not growing your account, not going beyond your comfort level, and it has the risk of regret.
So, in essence, everything we choose has some type of risk associated. We are the ones who have to measure the risks, and we tend to see stepping outside of our comfort zones as a risk, but there's also risk involved in remaining in them. So, this understanding comes from realizing what both risks are and which one is the one we actually want to take and that aligns with our long-term vision.
Now, let's talk about the three factors that affect risk tolerance in the hope that you can understand more about yourself and then adapt things to become more of the trader you want to be.
#1 Personality
The first factor affecting risk tolerance is personality. And for this I would like to start with a very important distinction, which is between risk type and risk behavior.
Risk is not all the same. So we have the risk type, which is developed more or less until our mid-twenties, and it's kind of established throughout our entire lives, and this is more defined for our personality. But then, on the other side of the spectrum, we have risk behavior, and this is something you can adapt. This is where your hopes to become more of a risk taker are because, with risk behavior, you can adapt to different market conditions and different situations.
You don't experience the same risk tolerance with all life and market situations — you might be very bold and be easy on taking risks when it comes to public speaking, talking with strangers, and socializing, and you're very communicative, but when it comes to for example to radical sports, you're a little bit more risk averse, or when it comes to financial decisions. So it really depends on the situation.
The same happens in the market: let's say when you have daily market conditions that you're comfortable trading, you will normally be a little bit more risk-seeking rather than having a consolidation on the daily time frame. You might choose to take trades still, but you might go for less exposure per trade.
To really understand the difference between risk type and behavior, imagine a boat floating in the ocean. Now, let's say this boat is attached to an anchor to the sand. The risk type would be this anchor. It sways a little bit in the sand, but not much. It's established. This would be defined by your personality. But then, when it comes to the risk behavior, this would be the boat – it floats around to a certain extent, defined by the anchor, but you can kind of steer the boat to your advantage, depending on the situation.
So, this is the idea. In the market, there are situations in which you're gonna want to be more risk averse, naturally. For example, going through a drawdown and tough market conditions - a good idea would be to cut your risk in half until you recover the loss back. And there are other situations where you naturally want to be more risk-seeking. Let's say with your A plus setups, with favorable market conditions. For some traders, this can be high volatility, earnings days, who knows. Each trader has their own favorable conditions for their edge.
#1 Experience
The second factor of fact in risk tolerance is experience, and this is an obvious one, right? The more experience we have in one task, hobby, or activity, the more a situation we create and the more we integrate the activity into our comfort zones.
So it's very normal that, for example, rock climbing is seen as a high-risk activity for some people, but then for other people who don't practice the sport and never did, it looks like, on the outside, rock climbers are crazy, and they are super-risk seeking, but in reality, the rock climber is mitigating the risks by their skill set, by gaining experience, by throughout preparation before climbing that rock. So, these skill set and their preparation allow them to manage the risks better.
On the other side, it might be that because it's a passion, they really love rock climbing, and it also becomes easier to be inclined to take risks in something you love. It takes less metabolic energy. For example, you're a trader, and you might have people in your family who think you are completely crazy because you're gambling, but what they don't really know is the ability to manage the risks that trading entails. And so, on the outside, they perceive it as a very risky seeking activity, when in fact, all we are doing is managing the risks effectively and mitigating them. And the more experience we gain, the more comfortable we become in taking those risks.
#1 Context
Now we have the third-factor affecting risk tolerance, and that is context; when we talk about context, We're talking about where you are, with whom, who's who is surrounding you. In what context are you?
Let's take the example of two traders: one trader who works for a trading floor with tight risk limits. They don't encourage their traders to be risk-taking and they actually punish them. They always keep things in a capital preservation mode. They don't adventure themselves much. Now, obviously, this trader will be more of a risk-averse trader, and he will have to struggle to take steps to be more risk-taking because he's in a context that doesn't favor that. He will just stay in his or her comfort zone for better or for worse. Now, consider the trader who works for a firm with wider risk parameters and they really encourage their traders to be more risk-taking and experiment, and you know, having fun with their trading, trying out new things. Obviously, this trader in this context who favors risk-taking will find it easier to take risks in certain scenarios. And because perhaps he's surrounded by a team that is risk-taking, and they were rewarded for that, you will be more encouraged to go ahead and take the risks.
Now, I encourage you to look at the personality aspect, your environment, and your context in general and understand more or less the conditions that make you more of a risk seeker or more of a risk-averse trader.
And then, with this information, you can adapt. It all starts with self-awareness, and from there, you can manipulate your environment and your context to become more of the trader you want to be.
Peaceful trading,
Sara
Hi Sara, it was a very good article, you shared valuable points in it, thank you