MANAGING RISK | KATA

Managing Risk 

The highly successful trader knows that one of the keys to winning is managing risk and learning how to lose gracefully. 

As new traders, our focus was on how much money we could make, while successful traders think about how much money they can lose. They focus on risk management.

That was a significant learning for us, and the good news is that this is something that you can do as well.

Time to earn the green trading belt.

Be Prepared For Losses

One of the most consistent realities of trading is that if you trade long enough, at some point in time, you will have losing trades.

How you manage those losses has as much to do with your long term success or failure as just about any other factor in your trading.

When you enter into a trade, you need to be OK about taking on a loss. You don’t have to like it; however, it’s best to accept losses as a real component of trading.

On that basis, you must identify and manage your risk effectively.

Emotions can run very strong when your trades turn into losers, and that’s why we believe that the first step, before entering into a trade, is to determine when you are going to get out of the market.

If you use a wait and see approach to trading, you put yourself into a position where your emotions take over your decision-making process.

As new traders, we often failed to identify the risk before entering a trade.  As a consequence, we quite often experienced one or more of the three stages of a losing trade.

The first stage is hope. You hope the market comes back from a losing trade to a winning trade.

When hope doesn’t work, you try wishing. You wish the market will come back enough to get out at the price that you got in so that you don’t have to take a loss.

Then comes desperation where you watch as the market continues to move against you, and eventually you get the dreaded margin call or a significant loss.

So what drives the three stages?

It’s hard to make decisions in the heat of the battle.

If you have real money on the line, you tend to make decisions based on fear or greed.

Make Decisions Based On Sound Analysis

We learnt the hard way that you need to make decisions based on sound analysis, rather than just the need to get out of a trade.

How many times have you finally got out of a bad trade and then seen the market reverse and move back in the direction that you wanted?

It’s happened to all of us.

However, those that decide not to let this happen to them anymore take a big step to becoming a better trader.

So determine your entry, identify your risk and project your potential profit again and again and again.

Highly successful traders know there is no guarantee that anyone trade will be profitable.

They detach themselves from the outcome of any one trade. But they know that after a series of trades the chances are good that they will be profitable.

It’s easy to keep your emotions out of your trading when you treat trading as a business.

Managing risk is a crucial part of treating trading as a business.

Position sizing, stop losses, and back-testing are a vital element of any trading strategy. Crucial elements in managing risk.

Be consistent in your approach and how you handle losses, as this is one thing that separates the good from the poor trader.

The Retail Trap

The typical retail trap, and a consequence of all the software packages, the ease of electronic trading and the indicators, is that most traders think of a trading strategy as “how do I enter the market?”

“How do I read these various metrics, or whatever I’m looking at, to try to find the one best place to enter, which will ensure that I win most of the time?”

That was the treadmill that we were on from the beginning.

We kept method hunting… trying to find something that makes sense to us.

We poured over tons of chart history hoping to get to the point where we could say “this is what I’m going to do, this is where I’m going to enter the market”.

As a consequence, we spent less time on the element that matters… Risk management.

How we bet, what the position size is and how we were going to adapt to volatility over time rarely featured in our approach to trading.

We were just focussed on the entry. When that stopped working, it was back to the drawing board.

The vast majority of traders, well into the 90% range, can’t escape it. They will never escape it.

We learned that in any strategy, it doesn’t matter whether its a short term quantitative strategy or otherwise, success is never exclusively linked to entry.

In fact, in most cases, the entry has very little to do with success.

Managing Risk – Learn From The Casino

Whatever your criteria are for entering a market, if it happens to work out the way you wanted, it may just seem like you predicted it.

However, if you understand what a market is and you know how it operates, and you understand that it’s just an auction, then you have to acknowledge that the deck is continually reshuffled — reshuffled like the deck of cards in the casino.

The notion that whatever you saw, or whatever was going on at the moment you entered the market several hours ago, has anything to do with you crossing an arbitrary price, at the point that you want to scale your position, is absurd.

On every tick, every second, and in every market, the participants are continually evaluating and re-evaluating.

If you focus on when this indicator lines up with this indicator, and you think that’s how you’re going to make your money… it’s not.

If that kind of inefficiency exists in the market, it won’t last for long. The market will eventually find it and will render it obsolete.

Focus on how to manage your money, not only managing risk on each trade but how you’re going to adapt to volatility or even how the markets change or move.

It’s just something that you have to do.

Most people that fall into the retail trap don’t want it to be adaptable. They want the easy route.

Red light/green light. “If this lines up with this, if this does this, then I get long, I go to the beach, and a year from now I’m just printing money”.

That’s the dream that a lot of people get sucked into.

There is just no light at the end of that tunnel.

Casino’s lose all the time. But they have an edge, a mathematical edge. They know that over time, and because of the edge that they’ve built into the games, they will be profitable.

At the end of the day, they’re managing risk and grinding out a risk model.

A Crucial Step In Managing Risk

The casino never meets with the blackjack dealers and questions why they have so many losing hands because the blackjack dealers can’t control what cards come out of the deck.

So when we talk about entries being the least important, in this context, your entries don’t have to mean anything.

There are other caveats, you have to be diverse, and there are other components like the number of events and opportunities.

The benefit of “playing” in the market is that it lets you set your payout odds.

A crucial step in managing risk.

In a market, nobody tells you how to set your betting structure. It’s your choice. If you want to set a 20% win rate or 15% win rate or whatever, you can.

You can say “I’m going to bet a pound and I’m not going to get out or accept a win until I’ve made 8 to 1 on my money” or whatever the number is.

You’re probably not going to like it psychologically, but it doesn’t mean that it’s not the best approach to make you the most money.

Typically what makes you feel good, as a discretionary trader, is never what’s going to get you the money.

Being uncomfortable with your trade is okay as long as you understand the risk.

The element of risk is ever-present and managing risk is key.

Stop Over Analysing

In our experience, being a trader in general, and especially a discretionary trader is all about managing discomfort (and it never gets any easier).

It’s just something that you have to accept and ensure that it’s not influencing how you should react, and how you should manage your position.

The critical thing that we learned to avoid, and it goes back to the psychology of trying to mitigate pain (which is very common amongst humans in general), is trying too hard to achieve a linear result.

Evaluating your prowess as a trader, or the effectiveness of your trading strategy, solely on its linear ability to produce results is misguided.

You have to stop over analysing every trade.

Any one event or any one trade, and what happens to that trade, really has nothing to do with anything.

“If I lost this trade, then I made a mistake, or if I win this trade, then I’m pretty smart.” is, unfortunately, the way a lot of people think..

The truth is that neither is true.

You win some, and you lose some when you’re trading.

You have to become very comfortable with that.

The average person that gets interested enough to open an account doesn’t last three months.

That’s not necessarily because they blow there account.

It just means that for whatever reason, and not that they don’t have what it takes to be a trader, they have lost faith.

Trading Is Pain

They lose faith because they are focussing on entries, hyper analysing each trade, using that as ammo to quantify success or failure.

They go back to the drawing board and try to create a new model. Rinse repeat, rinse repeat.

That’s it in a nutshell.

Most never get to the point where you can discuss what is wrong with their risk model because trading disables them.

It’s pain. Trading is pain, and you have to get used to losing and not thinking that it means that you’re making a mistake. That’s the biggest takeaway.

The risk management model that we use is very elementary. There’s nothing special about it in any way.

It demonstrates fully and simplistically everything that we have learnt and noted so far regarding managing risk.

It’s a straightforward application of bet odds and a simplistic adaptation to volatility and market manipulation.

Japanese Coy Carp | Forex Ninja Trader | Managing Risk

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Louis Llanes

“It’s more important to make money when you’re right, and to make sure that your losses are smaller, than it is for you to be right 90% of the time.”