Understanding Your Risk Limits

Risk management in trading isn't just about setting stop losses; it's also about understanding and respecting your risk tolerance. Risk tolerance is the level of loss you can accept without jeopardizing your financial or emotional stability. It's the amount of money that, if lost, won't force you to make drastic changes to your lifestyle or sacrifice your basic needs.

In other words, risk tolerance is the loss limit that allows you to remain calm and rational, even when the market moves against you. If losses exceed your risk tolerance, you might panic and make impulsive decisions that only worsen the situation. Therefore, it's crucial to know your limits and not take risks beyond your ability to bear losses.

Combining stop losses with risk tolerance is key to effective trade risk management. Stop losses act as a quantitative protection mechanism, while risk tolerance acts as a qualitative safeguard. By using both, you ensure that your losses remain controlled and don't threaten your financial or emotional well-being.

What is Your Risk Tolerance?

Determining the exact figure for your risk tolerance can be challenging. However, as discussed earlier, risk tolerance is closely related to your ability to remain calm and rational in the face of losses, without having to significantly change your lifestyle or even struggle to survive.

Since everyone's cost of living is different, even if they live in the same area, each individual's risk tolerance will also differ. Only you truly understand your financial situation and how much loss you can bear without affecting your well-being.

For example, let's assume your salary is $3000 per month, while your living expenses are $1500 per month. You also set aside $500 as an emergency fund for unexpected needs. In this scenario, your maximum risk tolerance is $1000.

You might ask, "Why is the risk tolerance $1000? Aren't the funds in the trading account and income clearly separate?"

It's true that your trading funds are separate from your monthly income. But, you will always use your income as a comparison to gauge how big your profit or loss is when trading. When you profit $10,000, you'll consider it a large amount because it's several times your monthly income. And the same applies when you incur losses, you'll always compare them.

Moreover, both your trading funds and the money in your bank account are ultimately part of your total wealth. If you lose money, whether through trading or other means, your total wealth decreases. Therefore, even if placed separately, trading losses also mean losing some of the money you earned from other work, so we must also consider this when determining risk tolerance.

But, this is just one of several approaches. In a different approach, traders often separate their trading funds from their total wealth. So, when traders decide to make a deposit of a certain value, they have from the beginning been willing to not count that amount in the money they have. So, their risk tolerance is no longer based on their total wealth or monthly income, but rather the total funds they have in their trading account.

However, usually unconsciously they will still compare the size of the trading risk with the money they use as living expenses or the money they get every month. But technically they still calculate it based on the total trading funds they use. For example, when traders use $10,000 in funds, while their monthly income outside of trading is $1,000, traders may have determined that their risk tolerance is $500 or 5% of the total funds. However, when they actually experience a loss of that amount, they will still consider it quite large because its value is equivalent to 50% of their monthly income from other work.

How to Use Risk Tolerance in Trading?

Stop loss sizes are usually determined by specific methods used by traders. For example, some traders determine stop loss levels based on support and resistance, supply and demand, risk-to-reward ratios, or even based on pip values like 50 pips, 100 pips, and so on.

Many traders are willing to minimize or increase their stop loss distances to match the risk they want to take. In fact, the methods they use to determine stop losses have been well tested and are the right distance to confirm that the market is truly contrary to their trades.

Of course, such a method is wrong and should not be done by traders. To achieve consistent results, traders must consistently use the same method, both in determining when they will open a trade, determining their stop loss and profit target. If they use methods that change all the time, the end result will of course also change.

Therefore, in applying risk tolerance to a trade, what is changed is not the method for determining the stop loss, but rather the lot size of the trade. Here's an example:

You open a buy position in EUR/USD with a stop loss distance of 100 pips. Your risk tolerance is $1000 while the total capital in your trading account is $100,000. So the risk tolerance is 1% of your trading capital.

To limit losses to only $1000 in that trade, you need to use a maximum lot size of 1 lot (if the EUR/USD pip value is $10). Of course, you can use a smaller lot size to be even more cautious.

This way, you don't need to change your way of determining stop loss levels and sacrifice your discipline in following trading rules and implementing your trading plan, just because you want to adjust your trading risk so that it doesn't exceed your risk tolerance.

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Understanding your risk tolerance might seem unnecessary. But, it's crucial to complement your risk management in trading. Using stop losses alone without knowing how much loss you can handle is futile, because stop loss distances aren't always static at certain pip values. They can become much wider when market volatility increases and narrower when volatility is low.

When market volatility is high, your stop loss could be hundreds of pips or even wider. If you don't adjust your lot size considering your risk tolerance, the potential losses could be significant. This will impact your overall trading results. Even if most of your trades are profitable, one loss during high volatility can wipe out those gains and render your trading efforts pointless.

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