One of the things that I learned from Pete Steidlmayer was to take calculated risks. Not that I am risk averse – that too was something I had to learn: the times when risk taking is unjustified.
What I learnt from Pete was that to succeed I had to take calculated risks and not to just take risks. There is a world of difference between the two ideas.
Just taking risk is akin to gambling, at least in my book. We take a trade not knowing if the probabilities favour our methodology, not having any idea about managing a trade, not having any idea of the risk of ruin the position size brings or whether the position size is worth the risk. When we take a trade in this state, we enter and hope for the best.
So what are the differences when we take a calculated risk? The differences, in two words, are knowledge and consequence.
Knowledge means that we know within the boundaries of our perception and methodology that over a large sample size, our $1.00 investment will return on average ‘$X’ (and an amount that is positive). Consequence means we have worked out the worst case scenario and have accepted those results BEFORE we take a trade.
In my own trading, I use a spreadsheet that:
- Asks me to consider the Risk. The $ at risk for the position size must be within my money management
- Then it considers the Reward:Risk. The ratio must fall into my Normal Expectancy Ratio Range. What I did here was to tabulate the results of all my winning trades and work out the mean and standard deviation of the Ratio. That gave me my ratio’s normal range: 1.89 to 2.4.
Consequently if a potential trade falls much below 1.89 I am unlikely to take it; and if it is above 2.4, I would first re-examine the trade and if the ratio holds true, I consider increasing my position size.In this way, I take calculated risks.