It’s impossible to make money as a trader without taking some risks. You’ve got to risk money to make money. But if you take unnecessary, or extreme, risks you may not survive to trade in the long term. For both financial and psychological reasons, it’s vital to protect your financial resources.
Risk is a part of everyday life. We take risks even as we complete the most mundane tasks, such as when we drive our children to school. We take risks when we fly home to visit our family for Thanksgiving. We even take a risk just sitting at home watching television, since there is a possibility, although a slim one, that some harm will come to us. It’s often wise to take reasonable precautions to protect our interests. When you drive down the street, for example, it’s prudent to wear seatbelts and be careful to drive at a safe speed. When it comes to trading, it’s also vital to have proper protection. Adverse forces may go against your trading plan, and unless you protect yourself, you run the risk of getting hurt, and with trading, that often means substantial hits to your account balance.
There’s also a psychological advantage in protecting your interests. Taking precautions eases some of the pressure. If you know that the worst-case scenario is something you can deal with easily, you’ll feel more at ease. You’ll feel a sense of freedom. Acting under pressure often leads to an error, such as misinterpreting market conditions. Proper protection, gives you the time and opportunity to think more clearly, make a calm, thorough survey of all possibilities, and take appropriate action. Risk management provides not only protection from financial loss but also gives the trader a psychological piece of mind.
There are many ways to manage risk. But one of the best ways is to develop a very detailed trading plan in which you estimate the potential risk upfront. For example, you may estimate how far the trade may move against you. When going long on a swing trade, you may reason that the most the price will go against you are the low of the previous week. That will give you an estimate of risk upfront.
Many trading experts also suggest making sure that the amount of risk you take is only a small percentage of your trading capital, so that should you lose on the trade, the loss will be at a minimum. Whatever approach you take to managing risk, the point is that managing risk has both financial and psychological advantages. Psychologically, you’ll feel a sense of security. Deep down, you will know that should you lose on the trade, it can’t hurt you very much.
It’s only a small part of your capital, and you know you can survive to move on to new opportunities. You will feel more relaxed. And when you feel calm, your mind will be open to all possibilities. You can gauge the market action more objectively than when under pressure. In all likelihood, your mind will move with the market, and you will be able to trade effortlessly and reach a peak performance mental state. And when you trade in a peak performance mental state, you will be able to realize the long-term profits you are seeking.