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[dc]”F[/dc]irst, know your risk.” Every trader has heard this, and for good reason: It truly is one of the most important elements of successful trading. Amateur traders get into a trade thinking about all the money they stand to make, while professionals always define the risk first. In fact, many times a trader may have no idea how much potential is in a trade. Support and resistance levels, ratios, and other price targets are unreliable guidelines at best; very promising trades often turn out to be duds, while trades that might have seemed to have been sub-par at the time of entry sometimes to out to be outstanding winners. (Some traders do run systems with fixed profit targets, but that is a consideration for another day.) In all cases, the most important question is “how much will I lose if this trade is wrong?”

Asking that question is absolutely crucial, and must be done every time, every trade without fail, but it is not enough. What is your risk? This intended risk, the amount you are planning to lose, is just the tip of the iceberg, and many more serious dangers lurk beneath the surface.

• Understand the expectancy of the stop / profit set you are using. Do not be deceived into thinking a tight stop is equivalent to low risk. Tight stops can actually carry much more risk than wider stops. Make a mistake here, and every trading decision you make works against you and drives you further from profitability–in some ways this is the ultimate risk because it guarantees that you will eventually fail as a trader.
• Understand the risk of correlated positions. Do not assume that six positions are really six positions. If you are trading equities, expect to lose on the long side and short side of your book as two units. If you trade commodity futures or currencies, correlations can often tighten at exactly the wrong moment. Understand the correlation risks that new positions bring into your portfolio, and the risks of shifting correlations.
• Though most short-term traders do not think in a portfolio context, the reality is you do have a portfolio any time you have multiple positions. Make sure you are thinking horizontally (across your positions) as well as vertically. MPT and VaR are flawed concepts in many ways, but you should understand them well enough to have an intuitive sense of how positions behave together in a portfolio.
• Risks like credit risk and counterparty risk are not academic abstractions.
• Consider gap risk. How will you manage a gap open well beyond your stop?
• Consider liquidity risk, and how it may change. For instance, it is entirely possible that the $50 stock you are trading may have a $0.75 spread when you need to get out of a position, and that your medium-size order may move the stock another point. Of course, this is not what we want to happen, but it will happen sometimes. Assess the risk as well as possible, plan for it, and do not react emotionally.
• Speaking of emotions, what are the risks that some event can cause a chain reaction that compromises your emotional control? This is more relevant for some kinds of traders and styles of trading, but no one, even on the institutional level, is ever truly immune.

No answers in this post today, but I do want you to start thinking about your risk in a different light. With every trade, every decision, there’s more at risk than we know. Make the commitment, today, to start thinking about your true risks in trading.