Risk

 

The next step is determining how much you’re willing to risk in any given trade. While the risk you’re willing to accept may vary from position to position based on your varying levels of conviction, we strongly encourage you to establish a consistent amount of risk per position.

The most effective way of determining the amount of risk you’re willing to accept in any position is to decide on a percentage of your account equity that you’re willing to risk. Maybe you’re willing to risk 1 percent of or your account equity in any given trade if you’re risk averse. Or maybe you’re willing to risk as much as 10 percent of your account equity if you’re extremely aggressive.

Take a look at several different levels of risk across three account sizes. (See Table 1.2)

Account Equity ($)	1 % Risk	2 % Risk	5 % Risk	10 % Risk
5000	50	100	250	500
50000	500	1000	2500	5000
500000	5000	10000	25000	50000

Table 1. 2 – Risk Levels

The table in Figure 2 is simple mathematics. The complexity enters the equation when you consider probabilities of winning and losing trades, particularly the probabilities of losing trades.

Let’s assume you prefer a 5 percent risk in your trading or investing. That is, you’re willing to risk 5 percent of your account equity on each and every trade. Now, let’s assume the unimaginable: you place 10 consecutive losing trades, one at a time. What will your account value be after 10 losing trades, assuming you start with a $50,000 account? (See Table 1.3)

Losing Trade	Account Equity ($)
	50000
1	47500
2	45125
3	42869
4	40725
5	38689
6	36755
7	34917
8	33171
9	31512
10	29937

Table 1. 3 – 5 % Risk

Your account will drop from $50,000 to $29,937 after ten straight losing trades. That’s a drop of roughly 40 percent! That’s before commissions!

Remember that the example in Figure 3 assumes a 5 percent risk per position. While 5 percent doesn’t seem like a lot, in reality it’s a huge amount of risk to be taking per trade.

It might be even worse if you enter 10 positions at the same time, starting with $50,000, risking 5 percent on each. You will lose $25,000 – 50 percent of your account – under this scenario.

You can imagine what will happen to your account under these circumstances if you risk 10 percent per position. Your account will go to zero.

Are these scenarios impossible? No! Granted, they are improbable. But they are still possible. You want to protect your account against the possibility of losing so much after a series of bad trades.

Let’s look at a different scenario, one in which you risk 2 percent of your $50,000 account. What might your account look like after a string of 10 losing trades? (See Table 1.4)

Losing Trade	Account Equity ($)
	50000
1	49000
2	48020
3	47060
4	46118
5	45196
6	44292
7	43406
8	42538
9	41687
10	40854

Table 1. 4 – 2 % Risk

A 2 percent risk per position results in a drop in your account from $50,000 to $40,854. This is before commissions. Sure, it’s still a very big drop. It’s about an 18 percent drop. But it’s manageable. It’s not debilitating. You can rebound from a drop of this magnitude.

It might be a little extreme to assume you will ever suffer through 10 consecutive losing trades. Maybe your losing streaks always end at two or three. If that’s the case, then you can afford to take on bigger positions and more risk per position.

But if there’s a chance, however remote, that you might hit a horrible losing streak of 5 or 10 straight losing trades, then you are better off using a smaller risk per position. Most professionals, in fact, are in the neighborhood of 1, 2, or 3 percent risk per position. With that in mind, we’ll use a 2 percent risk per position throughout the remainder of your learning the system.