Step 2 - Understand your risk appetite


This might sound cliché to many people but knowing your risk appetite is extremely important in trading. If you don’t know your risk appetite, then you won’t know the right amount of capital to commit to your trading venture and for each trade.

Some traders lose sleep over their open trade positions. This is absolutely unnecessary! If you are losing sleep over your open trading positions then you most likely are risking too much capital for your own good. You should review the amount of risk you are undertaking.

If you are new to trading, start small. Don’t risk everything that you have got or you might panic and commit silly mistakes.

Steps to determine your risk appetite

There are a few steps you can do to better understand your risk appetite.

1)      Know how much capital you can afford: Set aside your minimum emergency fund. No one has the same needs so there is no magic formula. A popular advice given is that one should have emergency funds for at least six months of expenses. However, each person has his own sets of issues to deal with. Hence, covering six months of expenses might be too much or too little for you. Talk to your financial advisor if you are in doubt. If your gut tells you that you are risking too much, then you should listen to your gut and cut back. Reduce the capital you use for trading in such a case and top up your trading capital at a later time.


2)      Know your support network: If you have strong financial support from family and friends then perhaps you can take more risk than someone who does not have family or friends to fall back on. However, your support network is really your last resort and it should never be abused. Never ever risk so much capital in trading that you have to rely on others to pay your trading debts.


3)      Determine your income lifecycle:Income lifecycle starts from the time you can start earning income till the day you leave this world. Income includes passive income like dividends and interests. Hence, at each stage of your life, the amount you earn, your income source and potential to earn future income may be different. For example, a typical young person who just graduated from school might earn less than someone in the same field who has twenty years of work experience but he might have higher income potential since he has a longer road ahead of him. While a retiree who no longer draws wages will find it very hard to recover once he loses all his capital. Hence, a person with less income potential should not risk all his capital in risky trades.


4)      Personality:Some people can take a lot of risk without losing any sleep while others cannot stand losing a dime in any form of investments even if it is only paper loss. Personality plays a huge part in a person’s willingness to take risks and ability to handle risks. It also plays an important role in determining your trading style. If you feel very anxious that your trade positions remain open at the end of the trading day, then you should consider whether you are risking too much capital or you must close all your positions at the end of each day. You will get to know your personality better after some trading experiences so you might need to adjust your trading system as you get to know yourself better.


5)      Other short term demands for your capital: You should seriously consider setting aside money that you need to spend in the near future, for example within 3 to 6 months, and not use it for trading. For example, if you absolutely need to use $50,000 to buy a house to live in within 3 months then you should try not to use that $50,000 in trading. It is not just that you are risking too much, putting money that you need in the near future could adversely affect your trading results as you might act rationally.

TIP: Statistics taught us that any event that has even a very small probability of happening will eventually happen – it is just a matter of time. Hence, never get greedy or complacent even when you become a successful trader. Most people fail most miserably when they are on a winning streak - ask Lehman Brothers and Merrill Lynch bankers. When you think you are becoming a gambler or you have a sequence of bad trades, then you should take a break from trading for a while to sort out your emotions.

Action List for Step 2

Refer to the Actual Book.