2 Types of Risk: Pros Use One, Novices the Other

We typically view risk as how much capital we stand to lose if we lose on a trade. This is our trade risk. I don’t risk more than 1.5% on a trade, typically less than 1%. If you are trading with a $5000 account, and risk 1% that means you can lose $50 on that trade. That is your dollar or trade risk.

But there are other types of risk in trading, associated with how we choose which trades to take.

Consider the following example. You want to buy the EUR/USD, and based on your analysis, you have a specific price you want to buy it at. But as the EUR/USD declines toward that level you are faced with two choices:

  • Buying at the price you set
  • Not buy at the set price and instead wait to see if you can get a bit better price, or wait for more information from the market to determine when you enter

Most traders don’t consider this choice a risk, but it is. And the risks associated with these choices are called Information and Price risk, respectively.

The example applies to any strategy or scenario. The key element of the example is this question: For your trades, are you taking planned entries, or when entry time comes are you altering it?

Information Risk

Information risk is when you take a price, based on your analysis and strategy, that you believe is a good entry point. You are giving up the prospect of attaining additional information. This is why it is called information risk. Had you waited another few minutes to take the trade, more price data is available and thus more information to make your trading decision with.  But you have your trade, based on your strategy, with defined risk and rewards, so you are willing to give up potential new information.

Price Risk

Most traders want lots of confirmation for a trade, but confirmation comes at a cost. By waiting for more information it is possible you may get a better price, you may also end up with a worse one, or miss the trade completely. Price risk is when you alter your plan in an attempt to increase profits, get a better entry, etc.

Notice the Difference?

Most novice traders take on lots of price risk in that they wait for all sorts of stars to align before taking one trade they hope will work out.

Professional traders on the other hand, don’t need as much confirmation from the market. This is because they follow a plan, and a few minutes of additional information doesn’t change the trading statistics of a strategy over time. Two minutes of extra information isn’t worth missing a trade for, so they take a trade as planned, at a planned price and that is it.

If a trader is taking on price risk–that is, always looking for more information, confirmation and a better price–there is a tendency to trade with no plan at all! If an entry point looks good, but then you waffle and wait for more confirmation, then your strategy is changing with every trade. Changing your strategy on every trade can only lead to inconsistent performance.

Love Uncertainty

Pros take information risk because they are willing to take a trade without knowing what is going to happen next. Pros know that they don’t know what is going to happen next. Therefore, they trade according to the plan which is proven to have a slight profitable edge, and trust in that. They give up the need for more information because an extra minute of information won’t help the statistics of their strategy over a great many trades.

Novice traders hate risk, and don’t won’t to lose on this trade (and every trade taken is THIS trade). So they wait for lots of confirmation and try to cherry pick the best entry point. In theory it may be appealing. Why buy at 1.2588 when a few seconds later you can buy at 1.2585? But you then need to ask yourself, if you were supposed to buy at 1.2588 and didn’t, why would you buy at 1.2585…or any price for that matter?

There is always a continual stream of new information coming available. Pros don’t care. They trade their strategy. Novices try to cherry pick, and it is a stressful and frustrating way to trade because what was a good price one second, isn’t the next.

Final Word

Give up the need for certainty. Take your trades, based on your strategy, with conviction. Give up the need for more information or a better price. ┬áPros know they will lose sometimes and so they play the odds, and don’t waffle on entries or exits. All trades are made according to a plan, and aren’t adjusted at the last minute.

Strategies, entries and exit tactics will vary by trader, but as a general rule you’ll find pros take information risk and just take the trade (being ok with uncertainty), while novices and unsuccessful trader take price risk, requiring more information but in the process giving up any sort of edge they have in the market.