From Fear to Confidence: Choosing a Strategy That Fits Your Risk Tolerance

Hello, fellow traders!

An important topic for traders is risk tolerance in the Forex market. Risk tolerance is the acceptable level of loss in a trading system that a trader consciously accepts in expectation of potential profit. Assessing your own risk tolerance is an important stage in a trader's development, because it allows you to determine a strategy that suits you specifically. The article also examines various factors that affect risk tolerance and gives recommendations for determining your own pain threshold for losses.

The first question traders ask after studying Forex market theory is the search for a strategy. Most beginners are interested in intraday trading, rapidly growing a deposit, and scalping on M1–M15 timeframes. However, trading theory recommends conducting analysis and building strategies on higher timeframes. They smooth out the noise of currency fluctuations and random microtrends that are present on minute and hourly candles.

Intraday trading is attractive because it makes it possible to earn daily profits, but in practice traders most often lose their deposit. Emotions, psychology, and discipline are the first things named as reasons for losing an account.

In reality, the main reason lies in the trader's risk tolerance. Understanding your own tolerance for losses allows beginners to avoid losing their deposit.

Risk tolerance can become the key to successful trading in the Forex market for a professional trader as well. Switching to a less risky strategy can remove a significant emotional burden, provide more time for analysis, and ultimately maximize profit.

Risk tolerance is the acceptable overall level of loss in a trading system that a trader consciously accepts in expectation of potential profit. The size of account drawdown directly affects trading decisions and results.

By choosing the “wrong” strategy, a trader with low tolerance will not be able to follow its rules despite every effort to maintain discipline. After a series of losing trades, orders will be closed with minimal profit, any temporary drawdown will cause doubt in trading decisions, and so on.

A trader prepared for risk, who does not doubt the strategy's profit potential or even knows that a deposit blowout is someday inevitable in the trading process, withstands abnormal drawdowns.  

In fact, this is a portrait of everyone trading with the Martingale system. Many years of experience and conducted tests, as well as the choice of instruments, give them a clear understanding of the “expected downsides.” They perceive growing losses as a chance to increase the trading lot and earn higher profit on a pullback. On the other hand, an adequate user of the Martingale strategy understands that they may “catch” a long-term countertrend that will lead to a blown deposit.

A trader must understand that there is no universal approach to determining acceptable risk, since this is a purely personal decision that can also change for a number of different reasons. Tolerance is influenced by the level of finances, knowledge, personal circumstances, greed, avarice, success, and trading failures.

A long-term positive result can make a trader forget that strategies “blow out” over time because of changes in trend and volatility. Sometimes it is hard to force yourself to optimize an algorithm that was once profitable; it is easier to believe that the current loss will soon turn into profit, or vice versa. Large losses force the trader to trade with high risk in the hope of “winning back” the deposit.

It is generally impossible for a beginner to understand their own loss “pain threshold.” Of course, there are plenty of tests on the pages of the TradeLikeaPro website and other specialized resources that help with this issue. Links to them can be found at the end of the article.

However, there is a set of initial steps and general recommendations that will help in determining risk tolerance. Why should you follow them? So as not to lose your deposit and to spare yourself excessive emotional distress.

1.       Assess your own financial situation

A trader must decide what income they expect to receive from trading Forex. How much money can they spend on the first deposit? Will there be an additional attempt to deposit funds after a blowout and in what amount? How will this affect their personal financial situation?

Thoughts about a backup plan and adding funds can increase risk tolerance. This factor should be taken into account by the trader by reducing the initial investment amount.

The first deposit, as a rule, is completely lost by beginners, but they do not grasp the risks of the almost 100% probability of losses. Therefore, the very first contribution to Forex is always overstated in  size.

 2.       Decide in advance on the size of future earnings

How much profit does the trader expect from the invested deposit? If a trader expects to double or triple investments over a short period, then large drawdowns are unavoidable.

Risk tolerance should always come to the forefront. A beginner must be prepared to lose half of the deposit in a short time. If losses lead to a failure to follow trading rules, it is better not to try to cultivate trade discipline in yourself. You can simply moderate your appetite for expected earnings and focus on a conservative trading approach.

 3.       Take a risk assessment test

Risk assessment tests will determine approximate risk tolerance. They usually ask questions about investment goals, time horizon, and financial situation to determine your level of acceptable risk. Honesty in your answers will help avoid future losses and choose a trading system without deep emotional involvement in losses.

 4.       Start with small steps

Regardless of the test results and choice of strategy, a trader should not rush to deposit the entire planned amount and choose large lots. The rush to make money is a sign of greed, and in Forex this feeling always leads to poverty.

Invest a small percentage of the savings set aside for currency speculation. Use a cent account if this amount is too small for trading.

The first results will make it possible to prove or disprove the trader's ideas about the profitability of the strategy. As the number of profitable trades grows, gradually increase the deposit, but only after assessing your reaction to the loss incurred. This way, the trader will understand what percentage of drawdown does not affect trading decisions and what losses cause mistakes, violations of strategy rules, and emotional discomfort.

5.       Monitor the results

It is important for the trader to understand, remember, and assess the emotional reaction to losses and profits. You can even write it down as ratings on some relative scale in a trading journal. This will help make a final reasoned decision about the acceptable level of risk.

By following these steps, a trader will determine their risk tolerance more accurately, make the necessary changes to money management, or even radically change the trading strategy taking into account individual emotional background, trading style, and financial goals.

A trader will have to choose several types of strategies if they want to take the factor of risk tolerance into account. In practice, Forex traders choose only one trading system, which they then modify “for themselves.” The problem is that a scalping strategy cannot be changed to the level of conservative trading with low risk.

To take the tolerance factor into account, a trader must:

Ideally, it is better to launch several strategies, some of which will be more conservative than the chosen base trading system. The trader will be forced to do this in order to keep up with monitoring several trading algorithms.

As a result, “natural selection” will occur: some trading system will blow out, some will turn out to be uncomfortable for the user, and somewhere, on the contrary, profit will begin to accumulate without much effort.

Understanding risk tolerance is the key to successful trading in the Forex market. By assessing their level of acceptable risk and developing a trading strategy that corresponds to it, a trader will be able to fundamentally change their approach to Forex trading and maximize profit.

What Kind of Trader Are You

Van Tharp Test

Do You Have a Chance of Becoming a Successful Trader?

Vanguard Investor Questionnaire

FinaMetrica Risk Profiling

Riskalyze

What is your main goal in trading?

a. Achieve long-term capital growth - 2 points

b. Generating income - 1 point

c. Speculate and potentially profit from short-term market fluctuations - 3 points

How do you feel about the possibility of losing money in the markets?

a. I am willing to accept some degree of risk in exchange for potential profit - 2 points

b. I am comfortable with a moderate level of risk, but prefer to avoid significant losses - 1 point

c. I avoid risk and prefer investments with low risk and low return potential - 0 points

What degree of market volatility can you tolerate?

a. I am comfortable with a high degree of market volatility and understand that it can lead to significant profits or losses - 3 points

b. I am willing to put up with a moderate level of market volatility, but prefer to avoid extreme fluctuations - 2 points

c. I prefer investments with minimal volatility and stable returns - 1 point

How important is it for you to beat the market?

a. It is very important for me to achieve returns that exceed the market - 3 points

b. It is somewhat important to me, but average market returns also satisfy me - 2 points

c. I do not care about beating the market; I prefer investments with steady and stable income - 1 point.

What is your time horizon for trading?

a. I am a long-term investor and plan to hold my positions for several years or more - 2 points

b. I have a moderate time horizon, and I plan to hold my positions from several months to several years - 1 point

c. I am a short-term trader and plan to hold my positions for several days or weeks - 3 points.

Test results

When you complete the test and count the points, you can determine the level of risk tolerance as follows:

0-5 points: Not inclined to risk

6-10 points: Moderate risk

11-15 points: High risk

A trader without a tendency toward risk may be suited to position trading or trend strategies on the daily timeframe. A trader with a high level of risk should try intraday trading or scalping.

Sincerely, Ivan Petrov
Tlap.io