V.11:2 (89-91): Guidelines For Risk Management by George R. Arrington

Guidelines For Risk Management by George R. Arrington

Risk control is an essential part of trading successfully. Effective risk management requires not only the careful monitoring of risk exposure, but a strategy to minimize losses as well . Understanding how to control risk exposure allows the trader, beginner or veteran, to continue trading even when the inevitable losses occur. S TOCKS & COMMODITIES contributor George R. Arrington offers guidelines for risk control.

While every trade involves a degree of risk, some general principles of risk management, if applied, reduce the potential for loss . A few of the generally accepted market axioms for controlling risk are noted below and are applicable to anyone who has ever traded or ever considered trading.


Rule 1: Do your homework.

Doing your homework before you trade is a must; there is no substitute. For every buyer there is a well-informed seller, and for every seller there is a well-informed buyer. Each is trying to maximize his return. Before you put your money at risk, you should have a solid, well-thought-out reason why you would buy something that someone else wants to sell. Trading, after all, is a zero-sum game. Ask yourself, what do I know that the seller (or buyer) does not? Be cautious and show some respect for the person on the other side of the trade.

You should have a clear understanding of the financial risk you face at any point in time. Part of that homework includes an estimate of the potential loss if the market goes against you by, say, 5% or 10% or 20%. Doing your trading homework also helps you calculate the worst possible outcome. These potential losses, together with estimates of the probabilities of those losses, provide a realistic picture of your risk exposure.