Tuesday, December 14, 2010

Controlling the controllable

The markets can be an unpredictable beast. Inexperienced traders jump in and out of positions at every whim of the market. This shows itself with irrational, emotional decisions on every pullback or move forward, entering and exiting positions at the wrong time, with little or no additional thought to controlling risk. To take a well known analogy, the tail is wagging the dog. This process needs to be reversed, so that we put the trader back in control.

Ok, so what aspects CAN you control?

Well, to start with you can focus on the trading process, rather than the outcome. In other, focus your energies on finding potential trades that match your own entry criteria, and then on controlling yourself when are in a trade, so that you do not contradict your rules for managing an open position and the subsequent exit from the trade. 

You have devised those rules for a reason - to give you that control. Do not put a spanner in the works and mess with the controls.

You can also control when not to trade - in day trading circles, this is known as 'SOH' (sit on hands) time. If your entry criteria is not being met, do not fight the market - wait until there are more favourable conditions. You want to put the odds in your favour as much as possible - forcing sub-optimal trades will erode your capital.

Finally, you can also control the risk and money management parameters with the use of initial and trailing stops - again, these should be clearly defined as part of your trading system rules.

These parameters mean that you fully control the negative side of any trade. A good trading system should only give you surprises on the positive side. This is particularly true of trend following systems. When trading such a method, you control the risk per trade and your overall portfolio risk at all times. As a result, you can fully quantify the downside. The upside however does not have any such restrictions, other than you only exit a trade when you get a signal identifying that the trend has ceased.

Every time a trend follower opens a position, there is no expectation of how much profit can be extracted - the market decides for you. You don't know how long the ride will be, or how far - you are simply going along for the ride. In other words, "cut your losses and let profits run".

In summary, the above points tell you where to focus your energies - on the areas that you can control. The rest of the time you simply 'sit on hands', observe what is happening and only need to do something when your system rules oblige you to.

2 comments:

  1. Hi Steve,
    Have you ever used fundamentals at all to narrow down your targets?

    ReplyDelete
  2. Thanks for the question - if I may, I'll keep that for the Q&A post.

    ReplyDelete