Thursday, May 02, 2013

Some thoughts on risk

"We know what we don't know. No matter what information you have, no matter what you are doing, you can be wrong. I have a friend who has amassed a fortune in excess of $100 million. He taught me two basic lessons. First, if you never bet your lifestyle, from a trading standpoint, nothing bad will ever happen to you. Second, if you know what the worst possible outcome is, it gives you tremendous freedom. The truth is that, while you can't quantify reward, you can quantify risk" - Larry Hite, from Market Wizards

No matter how big or small your trading account, you need to ensure that one trade, let alone a run of several losing trades, will cause major damage to your trading equity. The simplest way to lose a small amount on a position, is to trade a small position size, and resolve to close the trade when your stop is hit. 

One of the worst things to do is to specify your 'uncle point' where you will close a trade, only for the position to proceed to go against you and reach that price level. You then start having second thoughts, and start HOPING that the position will go back in your favour. Even worse, you may think about averaging down on your position. Big losses always start out as small losses. 

By letting one or two positions get out of control in this fashion, can erode several months of good results, achieved using proper risk control. 'Playing great defence' as Paul Tudor-Jones refers to it, will ensure you stay in the game, and should be you primary objective every time you open a trade (refer to this post for more).

Trend followers approach the markets and risk in a completely different manner. They know they will be proven wrong on a position frequently. However, they accept this, and trade using a risk per trade level that they are comfortable with, and which allows them to have an 'emotional indifference' towards whether the trade is a winner or a loser. They cut their losses as soon as their stop level is hit, no questions asked. 

By risking a small amount per trade, there is little damage to their equity. On their winning trades, however, they do not seek to close a position too early - who knows how far the trend will go? But again, by trading a small level of risk on each position, they have an 'emotional indifference' to a winning trade. By doing this, they do not FEAR a reversal against them and an erosion profits. They let the market do what it has to do. They cut their losses, and let their winners run.

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