One of the most common discussions about trading is how much risk a trader should take on each trade.
Many of them follow the standard 1% to 2% while some of the more aggressive ones sometimes recommend risking up to 5%.
What you need to understand is that risk is not a one-dimensional endeavor. Sure, there are basic rules to follow, but it is more profitable in the long run to take into account your personal preferences.
Risk tolerance basically tells you how comfortable you are with the possibility of losing money versus the potential profit.
People with a steady income or experience in the financial markets tend to be more aggressive, while those with other financial commitments and limited trading experience usually take the less risky route to profitability.
Unfortunately, this is not always the case for forex traders.
Many beginners are attracted to the prospect of making quick and easy profits, and because they have limited trading experience, they usually end up taking on more risk than they can handle.
The problem with risking more money than you are comfortable with is that the potential for loss can destroy your trading mindset and prevent you from making sound trading decisions. You will end up making your decisions based on your account balance rather than training.
For example, your demo trades show that you make the most profit when you place your stop loss 100 pips away from the entry price. But since you are not comfortable with the losses that a stop loss of 100 pips would entail, you close your losing trades as soon as possible.
Then you bang your head on the table when the price finally turns around and goes in your favor. You may resort to revenge trades and multiply your losses until you lose your entire account!
So how do you know how aggressive you should be on each trade? Here are some considerations:
Lifestyle
Do you have a steady source of income? If you expect to get regular paychecks, you won’t mind losing money here and there and can focus on your trading skills.
But if you expect your trading profits to become your sole source of income or to pay off your debts and other financial obligations, you are likely to have a lot of fear/greed based decisions and should stick to smaller position sizes.
commercial capital
How much have you invested in your trading? A larger trading account can survive larger trades per trade. Therefore, traders with small accounts should not trade standard lots or even micro lots that would trigger a margin call at the slightest volatility.
time frame
How long do you plan to keep your trades open? Position sizes are usually smaller for longer-term trades, as they need to withstand more volatility.
If you are a day trader or swing trader, you may be able to increase your average position sizes a bit.
expertise
If you trade long enough, you will have more confidence in your instincts and trading decisions.
In fact, increasing your position size may be the next step to improving your trading performance. But if you are new to this field and still making decisions based on emotions, trading smaller position sizes may be a better option.
Remember, there is no one formula for risk tolerance. You can read different books, blogs, and ask other traders on forums, but ultimately, how much risk you take on each trade depends on your risk tolerance.
You can start by risking 1% of your account on each trade and see how that works for you. Reduce this amount if you find yourself worrying about your balance rather than how well you are executing your trading plan. Increase your average position size if you find that the potential gains are not motivating enough for you.
You may not see it, but your risk tolerance affects every trading decision you make.
Find a happy balance that will make big changes in your account and allow you to focus on improving your trading skills at the same time, and you will eventually find your way to consistent profitability.
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