Risk in trading or investing is the probability of losing part or all of your initial investment. On the other side is the potential reward, the profit you could make. In general, we say that the greater the risk, the greater the potential reward or return on investment.
However, traders and investors are always looking for an edge, a way to get a greater reward or to take on less risk. To get a greater reward, they may look for ways to increase their leverage. To reduce their risk exposure, they may use stop-loss orders or use a hedging strategy. Because risk represents uncertainty, it is the variable part of your overall trading cost, but on Nadex, you can define the limits of that variable cost.
The relationship between risk and return on investment
A bank CD might offer an interest rate between one and two percent a year. That’s a relatively low return on investment, but the CD is insured by the FDIC, making it a safe investment. You get low risk in exchange for low ROI.
In contrast, imagine it’s 2002 and you joined the house-flipping craze, buying a run-down house to fix it up and resell it. In that early phase of the housing bubble, TV shows made celebrities out of do-it-yourselfers who sold their made-over houses for big profits. But when the housing bubble burst, many were stuck with properties that lost value and were hard to sell.
The potential rewards were big, but so were the risks. Somewhere in between those extremes are where most people put their money, in mutual funds and 401(k)s.
Risk management is the most important part of your trading strategy
The key to consistent success as a trader is to keep your losses smaller than your profits. It is generally easier to limit or manage your maximum possible loss than to determine your maximum possible profit. On Nadex, you can set your maximum possible risk down to the dollar before you place each trade. The amount you pay to enter the trade is your entire risk. You cannot lose more than your initial trade cost.