Tuesday, November 13, 2012

A trading paradox

One thing that many inexperienced traders find is that they suffer wild swings in equity, and can easily blow up their trading account if they are not careful. The main reason  I believe for this is that they trade too large a position relative to their overall trading equity.

One thing I found relatively early on in my trading career was the paradox that, the smaller the risk per trade I used, the bigger the profits I was making. As Ed Seykota would say, this was my "Aha!" moment. Why was this?

This all comes back to the famous Larry Hite quote in Market Wizards about having an 'emotional indifference' to each position.You can only do this if you are trading a small percentage of your equity on each position. This is particularly true in trend following, which in its pure form is an "absolute return" method. Trading small makes it easier to stick to the rules of the system, as it is less likely that feelings such as hope, greed and fear will sabotage your performance.

The rules for a decent trend following system can be understood by anybody, so why can't people follow them? I believe it all comes back to trading too large a position.

In my own trading, I would say that developing an emotional indifference to each trade was a direct consequence of utilising a proper risk management strategy, and was the catalyst for making money from the markets.

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