Risk Management

Discussion in 'Trading' started by Joe Ross, May 3, 2010.

  1. Is trading easy or hard? To the outside observer, trading seems easy enough. You merely pick what you want to trade, bet it will go up or down, execute a trade and see what happens. What's the big deal? If it were that easy, however, everyone would be doing it and making millions. Unfortunately, it is not that easy, especially in a sideways market or one that fluctuates wildly. In a strong bull market like we saw during the dot-com boom, amateur traders merely opened an online account and watched their account balances balloon. It all changed in 2000, though. We've seen a taste of "the good old days" in the past month, but even when the masses are interested and prices go up, trading is not easy. You have to work at it, and hard, to make profits across a series of trades.

    Successful trading is part financial resources, part trading strategy, and part psychology. Suppose that you had a simple trading strategy. You might decide to find markets that temporarily went down on general weak economic news, but by all indications, the markets should increase when clearer heads prevail. You look at all the information, and decide to develop a trading method based on "seller's remorse." That is, you anticipate that there will be those investors who sold in a panic on weak economic news and will buy back when they realize that the markets were still good buys. But there's more to it than good trading strategy. You must also decide how much capital you will devote to the strategy. On any one trade, you might risk 2-3%, but not all of your picks will go up in the way you had planned. Trading is also part mathematics. Some of your trades will come through, but others will not. You have to decide how many trades you will make and how much you will risk. And if you have the stomach to risk that much.

    If you have relatively low financial resources, taking a 20% risk may be hard to handle. You may feel it would be a disaster if your approach did not realize a substantial profit. Psychologically, taking the risk can be anxiety provoking to say the least. A jumble of thoughts may race through your mind as you execute the trades, and monitor them. As you anxiously await the outcome, you may barely be able to think clearly as your emotions overpower you.
    What do you do if you can't tolerate risk? An obvious solution is to simply take less of a risk. You may not want to make all 10 trades, for example. Instead, look for two or three of the 10 that are the most likely to produce a profit. You do not stand to make as much, but you are not likely to lose as much either. And if you have trouble tolerating risk, the piece of mind you get instead will probably be worth more than the profits you could have made, considering the financial and psychological risks it would require. What are the long-term consequences? On the one hand, it may seem that you will never make huge profits in the markets if you are not willing to take risks. After all, seasoned, professional traders put on big trades and it doesn't bother them. But you must decide if taking such big risks would be in your best interests. And until you are confident that you can make profits in market to market, you might want to hone your trading skills before taking big risks.

    Don't downplay the importance of risk management. There are financial and psychological benefits for limiting risks. A hard reality of trading is that there are few foolproof trading strategies. Even the most reliable strategy is bound to fail eventually. Market conditions frequently change, and when they do, your strategies must be changed also. The trouble is that you don't know when a strategy will fail or when it will not beforehand. Your best defense against the sporadic changes in market conditions is to limit your risk. If you limit your risk, you'll be able to survive the learning curve, and eventually, become one of the select few who profits big from trading the markets.
  2. Given the absence of reference in your post to backtesting as a method for gauging the reward available for the risk you can stomach and assessing the validity of your gut, does that mean that you do not backtest strategies?
  3. OMMFG! Is it Friday already? :confused: :eek: :cool: