Risk Tolerance
The maximum level of financial loss and psychological discomfort a trader can absorb without deviating from their strategy.
Risk tolerance is both financial and psychological. Financially, it defines how large a drawdown you can sustain without depleting capital to an irrecoverable level. Psychologically, it defines how large a drawdown you can sustain without abandoning your strategy prematurely.
Many traders discover their true risk tolerance only after experiencing live losses. Someone who theoretically accepts a 20% drawdown may actually abandon a strategy at −8% due to psychological stress. Calibrating position sizes well below the financial maximum ensures the psychological threshold is never breached.