Saturday, January 31, 2015

A sorry tale

Every few months, a close friend of mine who I've known for more than twenty years calls to me to talk about how well he is doing trading the markets. He runs his own business, which allows him time to watch the markets during the day. As a result he trades short-term, sometimes holding positions for a few hours, sometimes a day or two if the markets run.  He occasionally sends me screenshots of his trading account to proudly show off his gains.

Then he goes quiet and doesn't talk about his trading for a bit. I used to ask what had happened in those quiet periods, but in reality I didn't need to ask - I knew. And the worst thing was, it was the same fault every time.

This week, with the volatility in the markets, he had made a lot of money from Monday through Wednesday. The phone calls had started again, so I knew what was happening.

Then, Thursday night, I got another call. Only this time, he was in despair. I'd never heard him like this before. Despite there being a big intra-day move, he got in a position to go the other way. And he held on as it went against him. And he then averaged down on his position. And on those two trades, he had put on a position size ten times bigger than what he had been doing, when he was trading very cautiously and conservatively.

The end result? In those few hours, he lost all his winnings for the week, and most of his trading capital.

What had he done? Simple. He got over-confident and thought that, on the next trade, he'd make a LOT of money. So he pumped up his position size, and was now risking a significant amount of his equity on a single trade. As the loss started to grow, he waited, hoping that the trade would turn back in his favour, so he could at least get out at break-even. Then he started worrying about the loss of money. So he doubled up his position, even though the markets were clearly moving in the opposite direction. He then sat there almost paralyzed, until his stops finally got hit.

So he is now back at square one. Will he carry on trading? I don't know. In the past he's brushed it off, got back to trading very small, and started to build his capital back up. This time it has really shaken him.

He's read the books. He knows what to do. He's got a method which can make him money. And for a while, he can do it. The proof is there - his equity increases. Then all hell breaks loose.

Ultimately, the discipline and control you need as a trader comes from within. Poor risk control will destroy you. Strong risk control, on the other hand, can take you a long way.

Don't end up like my friend.

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