By Fernando Gonzalez, developer of Online Trading Academy’s original curriculum*
Posted: June 22, 2007

Any trader who knows his or her stuff will tell you that risk management is the single most important aspect in trading, regardless of style or technical strategy. Yet, most traders are really not able to define exactly what risk management is.

Let's pause for a moment and think: Can we define, in one brief sentence, what risk management is? "Loss control" would probably be the best broad definition, but, to me, this is a little more precise: In the business of trading the financial markets, risk management is the constant modulation of risk exposure to a constantly changing market. What is this exactly?

Most participants will relegate their entire risk management strategy to setting and adhering to "stop losses." But, this falls far short of what risk management really is. To relegate the entire risk management strategy to simple stop losses would be equivalent to saying "I am safe in my car because I have brakes." Needless to say, the "brakes" are only part of an entire system of managing risk in the constantly moving environment that is street traffic.

In this sense, the markets are the same as the streets. We can take many more actions to minimize risk than simply applying the brakes: There is steering, controlling the throttle, the path you take, "your trip preparation," mapping your route, the times you drive, the amount of driving you do, not driving while "under the influence".

In fact, there are so many factors that affect risk levels, we cannot possibly reduce our entire risk control strategy down to "brakes," or in the case of trading, "stop losses."

So, What Is "Modulation of Risk Exposure"?

How we make and lose money is the end result of our interaction with the market. If we do not interact, we neither win nor lose. If we interact too much, we assume higher levels of risk that may be "more than we can handle."

Risk management is the constant "adjustment" of our risk exposure based on two primary factors: Market conditions and, more importantly, our very own performance. How do we modulate or "adjust" our risk exposure?

There are 3 primary ways of modulating exposure:

SIZE: How large or small our positions are, based on our account values. The more we expose our account, the "larger" the exposure.

FREQUENCY: How often we are in-and-out of the market. The more frequently we trade, the more we are exposed to the markets' motions over time, the more risk we assume. Also, commission costs become a factor that significantly affects risk levels as we increase frequency.

DURATION: The longer we are in each trade, the more opportunity the market has to travel, the higher our risks will be.

In modulating risk exposure, imagine that we have a dial, much like the volume dial on a common stereo. When we want to increase exposure, we "raise" the "volume dial" and vice versa when we want to decrease exposure or move to "off:"

But, in trading, we really have 3 "volume dials." One to adjust size, a second one for duration and a third for frequency. As we increase one, we compensate by lowering another.

The biggest single error most traders make is to take one or more of the dials and twist it to the maximum. In essence, they "blow-out the speakers". In our analogy, the "speakers" would be the trading account!

A critical part of risk management, particularly for beginners, is to only increase the risk exposure whenever we have built what are called "buffer zones".

It is surprising that most traders do not recognize the idea of buffer building. In the figure shown previously, the inner black circle represents our trading capital. Our job as traders is to initially build a small buffer around that capital, perhaps only a few % of the account value. This is represented by the dotted gray line, and the trader's primary goal is to build the buffer around the account with limited exposure.

Once the buffer is achieved, then and only then can he or she "increase" the volume dial to a higher rate of exposure. The trader, then, will set a new buffer zone around his or her capital to protect the capital from future increases in risk exposure -- only increasing exposure once the buffer is built. This process continues perpetually for the trader's lifetime.

A trader who is correctly managing his or her risks, therefore, exists only in one of two primary states: Buffer building or capital preservation. If the trader is not building buffers, he or she is protecting capital. The state of capital preservation is the process of trading at absolute minimum risk exposure until the buffer is regained.

This method provides the trader with a specific focus on exactly what he or she needs to do -- set goals that are well-defined, achievable and incremental in nature. Having the correct focus makes "discipline" easier to carry out.

Build your buffers and modulate your risk: This is the simple process you need to follow and the path you need to take to grow your account. Stop losses are a critical part of this process, but they are merely a piece of a larger, more important process.

* Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com