Wednesday, February 08, 2012

The first thing you should think of before every trade

When designing a trend following system, there are a number of parameters that must be set - basically how to identify an entry and exit point, inital stops etc. But the most critical aspect relates to the amount of risk you attach to each trade.

Ideally, you want to risk a sufficient amount to make any profits worthwhile, but also to ensure that any losses do not do major damage to your trading account. As Market Wizard Larry Hite stated, he risked no more than 1% of his trading equity on each trade, so that he had an 'emotional indifference' to each trade he took.

Your first question should therefore be "How much am I prepared to lose on this trade?". I can bet that the majority of inexperienced traders simply look at the potential £££'s or $$$'s that they can win if a trade works out, rather than what they can lose.

As a secondary point, you need to consider the potential overall risk to your trading account - you can reduce this by diversifying your trading activity over a number of different positions, but there should be an overall limit as to the total risk in your portfolio at any time. This was referred to as the overall heat in your portfolio by trading legend Ed Seykota.

This can be slightly problematic if you are trading with a very small account - the simplest way to get round this is to reduce the number of positions you are allowed to trade at any one time, with a view to implementing a proper risk management plan as soon as practicable.

Both these issues form an integral part of a good trend following system.

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