Risk is dangerous. Risking anything means I could lose it. Purchasing a stock could result in a loss of equity in my account if the stock goes down. But the risk of doing nothing could be just as damaging because inflation will eat away at my purchasing power. To avoid this risk of simply doing nothing I’m forced to take the risk of doing something. It is this realization that I am being forced into accepting risk whether I do something or nothing is what resonates at the core of my financial existence. If I do nothing I am sure to lose and if I do something there is a serious potential for loss. I have no choice. I’m forced to accept risk. Risk itself is inherent in life as life moves through time.
Once I come to terms with risk and this fear of financial loss, I come to understand that I must take on risk in order to at least keep up with inflation if I am to maintain the purchasing power of my savings. If all I want to do is maintain that purchasing power then I look for the minimum risk that I’m required to accept. For me risk is defined as the probability that my trade will end in a loss. It’s the chance of losing money when I buy and sell stocks and options. For me it’s also directly related to the chance of making money in the market. The more risk I take on, the more reward I expect to make.
This risk and reward are simply fear and greed. They’re the same fear and greed that move the markets. They’re the emotions that excite and paralyze every investor and are the cause of so many mistakes in trading. For most traders the fear of loss is a greater emotional event than greed and will drive trading decisions to a greater degree than greed, but both emotions will interfere with the logic of trading and ultimately interfere with an investor’s trading plan.
It’s because of these two emotions that a trading plan becomes an absolute necessity. A good trading plan will describe the conditions for entering a trade, exiting a trade, and the subsequent transactions when the trade goes sour. All three parts of the plan are necessary because of the existence of risk. The minute I enter a trade I’m putting my money at risk. I could be completely wrong in understanding the situation or I could be exactly right yet my timing could be completely off. Because of risk the trade may immediately start to lose money. Since that possibility always exists, I need to know what to do even before I enter the trade. Without a plan I’m immediately subject to my emotions and I end up doing either nothing or the wrong thing. Both of these decisions would have a disastrous effect on my accounts.
"Life is inherently risky. There is only one big risk you should avoid at all costs, and that is the risk of doing nothing."
-- Denis Waitley, Author, Consultant, and Motivational Speaker.
Understanding the debilitating effects of risk and the need to control the emotions associated with risk by developing a trading plan was the beginning of me becoming a successful trader.