July 7, 2006

Winning At All Costs

"Damn The Torpedoes" was Admiral David Farragut's famous battle cry, and historically speaking, the decision to risk everything for an important victory during the Civil War battle at Mobile Bay worked out very well. But when you're taking risks to trade the markets, allowing yourself to get caught up in the moment and take on more than a prudent level of risk is almost certain to get you burned, sooner or later.

Many people unconsciously adopt a "damn the torpedoes" approach after either a big loss or a big gain in the markets. After a loss, you might hope to win it all back or even get ahead. After a gain, you might feel impervious to market forces. Either way, there's a possibility you're letting your emotions crowd out your more logical, sensible self, which is always a bad idea when trading the markets.

There's nothing more thrilling than anticipating what the markets will do and making a huge profit off of your astute observation. Not only do you feel on top of the world for getting it right, but the feeling of security from realizing a windfall is nice too. After a winning streak, it's tempting to let loose and start making some big trades. It is tempting to start thinking, "What do I have to lose? I'm far ahead of the game. I can take a little more risk." Although it is often useful to take advantage of a hot streak when you hit upon one, it doesn't mean that you should act recklessly. It's essential for long-term survival to maintain discipline and manage risk (for example, through protective stops, options, or risking a minimal amount of your account balance on a single trade). It is essential that you fight the urge to trade impulsively. You must maintain discipline.

What is the harm of taking unnecessary risks? Market uncertainty is the main reason. You really don't know with 100% certainty that your next set of trades will be wins. When you take unnecessary chances, it's as if you are working under the assumption that you will definitely win in the future. But no one has a crystal ball. Trading is about taking advantage of probabilities, and working under the assumption that if you make enough trades (and manage risk with each trade), the law of averages will work in your favor. That said, from the perspective of probability theory, it's possible that you will hit upon a string of wins, and by making larger trades and lowering your limits, you'll reap big rewards. But at the same time, you may also encounter a string of losers. If you act impulsively, or abandon your risk management plan, you'll tend to give back all your profits and more. It's vital for your long-term survival to continue to manage risk, even after a long string of successful trades.

It is tempting to feel you can abandon risk limits and go for the big wins no matter what the costs. Some of the most profitable Market Wizards have put their financial life on the line and made huge profits, but there are also those traders who spent the rest of their lives trying to pay back losses. In the long run, it's better to survive. By managing your risks, you will increase your odds of success.

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