Risk tolerance and trading – finding the perfect balance

Risk tolerance and trading – finding the perfect balance

Financial analysts know how important it is to manage risks if you plan on trading.

Financial analysts know how important it is to manage risks if you plan on trading. However, how can you do that efficiently? Which are the pieces of the puzzle required to build your risk tolerance and become a better trader, in full control of his strategies, plans, and tools?

In the few lines below, we will cover one of the essential concepts in financial trading: risk tolerance. We will tackle important topics such as financial planning, understanding volatility, asset allocation & portfolio diversification, and panic selling.

Without further ado, let’s start with the basics.

What is risk tolerance?

Risk tolerance should reflect how much you afford to risk when trading. Usually, experts advise risking a maximum of 10% of the total value of your account on each trade. Still, it all comes down to your trading expertise. By risking up to 10% of your available equity on every trade you place, it means you could squander all your funds at ten consecutive losses. By reducing the percentage to 5%, for instance, you would need to lose 20 trades in a row to end up losing your funds.

Usually, investors fall into one of the three categories of risk tolerance: aggressive, moderate, and conservative, depending on their financial planning.


Planning ahead

Having a reliable, adaptable plan that's working for you should be the very first thing on your agenda before jumping into trading.

Since much has been written on this topic, here are the most important things to consider when working on your trading plan:

Take your time to evaluate your market knowledge – determining with precision how much you know about this business sector allows you to set the direction of your trading path

Establish your objectives according to your style of trading – setting up realistic targets, as well as entry and exit points for your trades is vital

Don’t forget about risk management – depending on your skills and goals you need to decide how risky your trading approach should be

Keep records of your every move – having a journal with your entire trading activity can help you tremendously on the long run in adapting and improving your strategies

Finally, keep in mind that you can readjust your trading plan on the go, as you gather more experience – it’s not set in stone forever!


Understanding volatility

Volatility is a critical concept in trading. In simple terms, it measures the price fluctuation in a market over a specific timeframe. Volatility is usually triggered by news releases (both positive and negative) or financial & economic events. Traders measure it via volatility indices such as the VIX.

Examples of recurrent volatility triggers: NFP reports, Central Banks’ Monetary Policy Decisions, Black Swan Events (Covid-19 pandemic), and many others. Depending on how hard these events can affect specific instruments, volatility levels can be more or less impactful.

What you should keep in mind is that volatility is at the same a trader’s biggest friend and his worst enemy. It can create great trading opportunities, but it can also lead to substantial losses if handled without enough care. Luckily, there are quite a few measures you can take in order to ensure you're on the right path and you're always prepared for what volatility might bring.

For instance, if analysts expect jobs count to rise in the U.S economy and the actual NFP result turns out different, then the U.S Dollar Index might plunge. The Forex market will experience volatility, and if you were already trading according to the market sentiment*, you would need to adjust your strategies to limit risks.

“How can I counter volatility?" you might ask yourself. It's the classic "easier said than done" scenario. A focused mindset and iron discipline could do the trick, but you should also work out your asset allocation.

*The market sentiment defines the traders’ overall mood regarding a certain financial market. The market sentiment can be either bullish (if traders feel positive about what’s going to happen) or bearish (if traders are pessimistic about the future).


Fine-tuning your trading portfolio – asset allocation strategies

A sound asset allocation strategy is crucial for countering potential volatility spikes and keeping your investment portfolio under control. Besides, if you chose what to trade wisely, your overall returns might receive the boost you planned all along.

As an unwritten rule, asset allocation strategies should reflect your risk tolerance level and your trading goals. There are several strategies you can employ, including strategic asset allocation, tactical asset allocation, or dynamic asset allocation.

The strategic asset allocation is a method of diversifying your portfolio by trading instruments from various asset classes based on expected rates of return for each asset class.

The tactical asset involves moving from short-term trading when you achieve your profit targets to long-term trading by rebalancing your asset portfolio.

The dynamic asset allocation requires the most attention from your side since you'd need to adjust your assets choices as markets rise and fall. Ideally, you'd look to sell what's falling and to buy what's rising.

In conclusion, it’s advisable to stick with asset allocation strategies suitable for your style of trading. This way, you can avoid emotional trading that often leads to panic selling – the last key concept for the day.


Panic Selling – what happens when the unexpected occurs?

When large groups of investors lose their confidence in a specific market sector or security, they might be tempted to get rid of the impacted assets at an accelerated pace.

Panic selling can occur because of unexpected global catastrophes (see Covid-19 pandemic), impactful short-term developments (U.S – China trade war), or similar events. It is usually triggered by the strongest emotion of them all - fear.

In such scenarios, you should assess your situation with the utmost attention. And always keep in mind: there’s always a balance in the financial markets. When the dust settles, the sun shines again. Stay true to your plan and don’t give in to panic!

Interested in learning more about trading the financial markets? Check out our Academy, full of educational materials and resources designed to help you develop suitable trading strategies and gain valuable market information!


Sources: Investopedia.com, babypips.com

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