Respecting Risk
Is trading easy or hard? To the outside observer, trading seems easy enough. You merely pick a stock, 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 stocks that temporarily went down on general weak economic news, but by all indications, the stocks 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 the stocks back when they realize that the stocks 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 it's not just the number of trades that matter. You also must look at the range at which the price is likely to move. So, for the sake of argument, suppose you decide to risk 2%, on average, on each trade, and suppose you decide to make 10 trades using your seller's remorse strategy. That is a 20% risk. Psychologically, you have to be able to handle the risk. If you lose 20% of your capital, it will be difficult to make it back. Depending on your risk tolerance, it may be hard psychologically to risk 20%.
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. Seasoned traders have established trading skills and rock-solid confidence. If they lose a large stake, it would certainly be a setback, but they know that they have the ability to make the money back, eventually. On the other hand, if you are not yet confident as a trader, you know deep down that it's quite possible that you can't make back the capital that you lose. No matter how hard you try to ignore this possibility, you know in the back of your mind that it's a real threat, and it will haunt you.
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.
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 stocks that temporarily went down on general weak economic news, but by all indications, the stocks 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 the stocks back when they realize that the stocks 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 it's not just the number of trades that matter. You also must look at the range at which the price is likely to move. So, for the sake of argument, suppose you decide to risk 2%, on average, on each trade, and suppose you decide to make 10 trades using your seller's remorse strategy. That is a 20% risk. Psychologically, you have to be able to handle the risk. If you lose 20% of your capital, it will be difficult to make it back. Depending on your risk tolerance, it may be hard psychologically to risk 20%.
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. Seasoned traders have established trading skills and rock-solid confidence. If they lose a large stake, it would certainly be a setback, but they know that they have the ability to make the money back, eventually. On the other hand, if you are not yet confident as a trader, you know deep down that it's quite possible that you can't make back the capital that you lose. No matter how hard you try to ignore this possibility, you know in the back of your mind that it's a real threat, and it will haunt you.
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.
posted by nomadhunter at 5:41 PM
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