5 Ways to Master Risk

by Darrin Donnelly on March 22, 2011

Traders must learn to master risk.

Trading stocks is a risky business.  Of course, “risky business” is one of those terms that restates the patently obvious; that is, there is no such thing as a business that isn’t risky.

But still, trading stocks, especially when it IS your business, takes risk to a whole new level.

Risk is what fuels capitalism and the world of trading is the epicenter of capitalism.

If there was no risk involved in trading, there would be no way to profit.  And the less risk you expose your investments to (Treasury bonds, for instance), the less potential for reward you have.

With this in mind, traders are a rare species. 

A successful trader learns to go AGAINST the psychological condition all humans are imbedded with; the psychological condition that screams at us to AVOID risk.

A trader chooses not to avoid risk.  He embraces risk.  To succeed as a trader, he must MASTER risk.

What must you, as a trader, do to master risk?

1) Learn to LOVE the Risk

Stop fearing the risk.  It is what fuels the market.  Without risk, you couldn’t make any money playing this game, there would be no competition, and, frankly, it wouldn’t be any fun.  Stop seeing risk as the enemy and start thinking of it as your ally, something you can use to achieve what you want.

2) Control the Risk

You CAN control risk much more than you realize.  You can’t control all of it, but you can control most of it.  A trader controls risk by knowing exactly how much he is willing to risk on a trade.  This means knowing what your “worst-case-scenario” exit will be on every trade you enter.  If this trade goes against you, how much will it cost you?  What percentage of your portfolio will a worst-case-scenario loss account for?  (Your answer, by the way, should never be more than 2% of your portfolio.)  Control the risk and don’t let risk control you. 

3) Make Sure the Potential Reward is Always Greater than the Potential Risk

This sounds like kindergarten-level advice, and it is, but it’s amazing how many people enter a trade without knowing exactly how much they’re risking and exactly how much they’re planning to make.  A good trading system needs to have a reward-to-risk ratio of AT LEAST 2-to-1, but preferably 3-to-1.  This reward-to-risk ratio won’t always be hit precisely on every trade, but your trading system needs to play out at this ratio over the long term.

4) Make Sure Your Trading System IS a System

This means making sure that your trading system is mechanically driven and not emotionally driven.  That right there is one of the major keys to alleviating the fear of trading.  There is always some art and discretion to successful trading, but it needs to be minimal and practical.  My trading is about 85% mechanical/science and 15% discretion/art.  I’d prefer to keep this ratio closer to 90%-10% and if it ever gets closer to 80%-20%, I know I need to step back and reevaluate what I’m doing.

5) Be Humble

You must accept the fact that the future is unknowable.  What you “think” and “hope” will happen often doesn’t, and for reasons outside of your control.  The realities of any given circumstance are constantly changing and you have to react to these realities without bias.  Check your ego at the door and admit when you’re wrong, you’ll sleep better at night.

* Master your risk by joining Darvas Trader PRO, where you receive access to the full portfolio of Darvas stocks – with EXACT buy points and sell points.  You can check out the latest issue of Darvas Trader PRO by clicking here.

{ 2 comments… read them below or add one }

Sam March 22, 2011 at 6:14 pm

Great article Darrin. Thanks for taking the time to share and write.

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Darrin Donnelly March 22, 2011 at 6:29 pm

Thanks Sam, I really appreciate that!

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