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Understanding Trading Risk

Understanding Trading Risk

Understanding Trading Risk

The first thing any novice investor says about trading in the financial markets is, “It’s too risky,” or “I have a financial advisor who handles my investments.”  Yes, there is always risk any time we or someone else invests our money. When we allow someone else to be responsible for our financial success, we assume that it is less risky because they know what they are doing, right?

So, if we take that same idea, could we also not assume that if we educated ourselves, we could handle our own finances, while still managing some of the risk? Not to mention, we have complete control over our investments, we can check them daily, we could have options to make money during a crash, and one of the biggest incentives, we are not paying someone else to do it for us. Remember it is all about our return on investment (ROI).

Can we eliminate all risk? Of course not, and if anyone ever tells you they can…run! We cannot predict the markets with absolute certainty. What we can do is educate ourselves to minimize and manage that risk with education. To do this, we must understand risk and what it is.

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There are two types of risk to consider when it comes to trading. First is our Trade risk. This is the difference between an estimated entry point and an estimated exit point. Essentially, the maximum amount of money you would be comfortable losing on any given trade. Second is our Allocation risk. Yes, it does cost money to buy something, that is true, even in the financial markets. Allocation risk is how much capital you are willing to spend to open a position. The maximum amount of money you would be comfortable allocating to any given trade.

For example, if you estimate buying a stock at $32.00 and sell if it hits $28.00, your trade risk is $4.00.
$32.00 - $28.00 = $4.00

Now, let’s look at our allocation risk. Like I said, there is a cost to doing business. Let’s say you want to buy 100 shares of a $10.00 stock. 100 shares x $10.00 = $1,000.00 Or maybe you trade options (check out our Club content for more information on Option Trading), and you want to buy one option contract at $4.00.  100 X $4.00 = $400.00

Again, to understand in dollars. You have that same $10,000.00 in your account and you allocate $2,500.00 to a trade; you are comfortable allocating 25% of your account to making that trade.

In any trade, we look at our Risk vs. Allocation … How much are we willing to risk and how much is it going to cost us. Would we be willing to allocate more money to a trade if our risk were less? Or vice versa, would we be willing to risk more if our costs were less?

Whatever your risk rules are, it is imperative that you are consistent and abide by those rules on every trade. Remember, the number one rule of trading is, Do Not Lose Money! Taking control of your trades and money management are one of the ways to build wealth. Education and learning experience from others helps you leverage your time and money.

Areas of Review

Takeaway

Big picture takeaway points

  1. Why pay someone else to manage my money when I can get an education and manage it myself.
  2. While we cannot eliminate the risk, we can reduce it greatly.
  3. I can set up my own rules but I must follow them consistently.

Reflection

Self-reflection questions to think more about the content

  1. How much money am I willing to “risk” in order to purchase?
  2. How much money am I willing to “risk” before I exit a trade?
  3. Why do I want to pay someone else a fee to be responsible for my financial future when I could take that fee and put it towards my education to learn how to manage my finances myself?

Legacy’s Building Wealth Club offers you the financial education needed to pursue your goals. Let our education and experience lead the way!

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