Learning objectives
After studying this chapter the student should be able to understand:
• Why to put stop loss and use optimal trade size
• Qualities of successful traders
• Do’s and Don’ts in trading
• Trading along with trend
• Choosing the Right Markets to Trade
• Importance of Discipline in trading
7.1 Introduction
It is generally noticed that when we invest or trade our focus is on potential gains rather than dwelling on possible losses. Traders are often so confi dent about their trades that they push back their minds and don’t think that something could go wrong. But in order to be successful trader, we must keep our mind open to the potential losses and we should know how to manage and control those losses.
If you are making huge profits in the market on a very small or average trading account, it is most likely that you are not implementing sound money management. May be you are lucky for one or two days that has earned you windfall profits. But you have exposed yourself to obscene risk because of an abnormally high “Trade Size.” If you continue trading in this manner, probabilities indicate that very soon you would land up with series of losses and you may loose your entire capital.
Trading, like every other business, needs to start with a certain amount of equity or “seed capital”. Traders remain in business so long as they have this seed capital with them. Many traders start and end their trading capital in just one month! By not controlling risk and by using improper “Trade Size” a trader can go broke in no time. It usually happens like this; they begin trading, get 5 to 8 losses in a row, don’t use proper position size and don’t cut their losses soon enough. After 5 to 8 devastating losses in a row, their funds become too small to continue trading.
Novice traders tend to focus on the trade outcome as only winning and therefore do not think about risk. They don’t ask themselves, how much can they afford to lose on this trade and hence they fall prey to the “risk-of-ruin” outcome. Failure to implement good money management program will leave you subject to the deadly “risk of ruin” exposure leading eventually to a probable equity bust.
Professional traders focus on the risk and take the trade based on a favorable outcome. Thus, the psychology behind ‘Trade Size’” begins when you believe and acknowledge that each trade’s outcome is unknown when entering the trade. You either adjust your “Trade Size” or tighten your stop-loss before entering the trade. In most situations, the best method it to adjust your “Trade Size” and set your stop-loss based on market dynamics.
During “draw-down” periods, risk control becomes very important and since good traders test their trading systems, they have a good idea of the probabilities of how many consecutive losses in a row can occur. Taking this information into account, allows the trader to further determine the appropriate risk percentage to take on each trade.
Let’s talk about implementing sound money management in your trading formula so as to improve your trading and help control risk. The idea behind money management is that given enough time, even the best trading systems will only be right about 60% to 65% of the time. That means 40% of the time we will be wrong and have losing trades. For every 10 trades, we will lose an average of 4 times. Even certain trading set ups with higher rates of returns nearing 80% usually fall back to a realistic 60% to 65% return when actually traded. The reason for this is that human beings trade trading systems. And when human beings get involved, the rates of returns on most trading systems are lowered. Why? Because humans make trading mistakes, and are subject from time to time to emotional trading errors.
If we are losing 40% of the time then we need to control risk! This is done through implementing stops and controlling position size. We never really know which trades will be profi table. As a result, we have to control risk on every trade regardless of how sure we think the trade will be. If our winning trades are higher than our losing trades, we can do very well with a 60% trading system win to loss ratio. In fact with risk control, we can sustain multiple losses in a row without it devastating our trading account and our emotions.