Friday, November 23, 2012

Difference between Loss and Risk

Can you trade without a loss ? Suppose I say that yes, this should be the objective for every trader. Surely, the reader will find fault with this statement. No one can assure that every trade will be profitable. Again, you are correct. In fact, I usually say that trading losses are the cost of doing business.

So, what's the catch ?

I wanted to make a distinction between a loss that causes damage to your capital, and risk that is part and parcel of trading.

A loss occurs because of careless money management. The trader is fully responsible for such careless behavior. You must trade with the objective of zero losses.

Alexander Elder, in his book - Come Into my Trading Room, gives an example:

Imagine you’re not trading but running a fruit and vegetable stand.You take a risk each time you buy a crate of tomatoes. If your customers do not buy them, that crate will rot on you. That’s a normal business risk—you expect to sell most of your inventory, but some fruit and vegetables will spoil. As long as you buy carefully, keeping theunsold spoiled fruit to a small percentage of your daily volume, your business stays profitable.
Imagine that a wholesaler brings a tractor-trailer full of exotic fruit toyour stand and tries to sell you the entire load. He says that you can earn more in the next two days than you made in the previous six months. It sounds great—but what if your customers don’t buy thatexotic fruit? A rotting tractor-trailer load can hurt your business and endanger its survival. It’s no longer a businessman’s risk—it’s a loss.

The Successful trader respects his money. She will never allow losses to overwhelm her capital. Many trades will not work out, and there will be small losses. Sometimes, there is a run of losses when several trades do not work out. That's trading.

The amateur trader will throw his money at wild ideas. As beginners luck, he is likely to make money initially, then lose his entire capital when the market refuses to give him money for his stupidity.

Understand the difference between loss and risk. trading is about management of risk, and zero allowance for losses.

1 comment:

Dinesh said...

Dear Sir,
Thanks for sharing this. It is very useful. People do more research to buy a shirt worth less than 1 K than they do before investing 1 Lakh in the stock market. On a lighter note, I loose money even after research / analysis.