Saturday, June 11, 2016

An example of how emotions can affect your risk to reward performance

A couple of years back I had a meeting with a trader who wanted to improve. He had taken a break from the markets, and came to me for help in putting together a clear plan in place with good risk management and having the right mindset at the top of his list of priorities.
I've talked in the past about how closely your attitude to risk can affect your level of emotional control, and ultimately your discipline, as a trader.

With this in mind, we talked at length about his previous trading experiences and in particular his most profitable trade, which was this set up on the a UK stock. Here is the chart:

As you can see, there was a clear consolidation before a breakout in late November which produced a beautiful uptrend, and therefore you can understand why this trade generated a big profit.

However, I will now show you when and where he actually entered and exited the trade:

What had happened?

Put simply, he was unable to follow the rules he had set down in terms of entries and exits because his position size (and therefore the amount of risk taken) was excessive for his level of equity. As a result, when the upwards price movement paused and suffered a single down day, he became anxious and nervous that he would lose what profits he had. So he bailed out of the trade, and was then stuck on the sidelines as price continued to move upwards over the subsequent three months.

So, while he made a decent profit (in monetary terms) on that trade, when measured in terms of risk and reward, it was a poor return.

This is a classic example where emotions were allowed to come into play, because of the excessive risk taken. This didn't allow the trade to generate the profit in terms of R that it should have done.

In this particular example, we actually worked out that, had he used a more appropriate level of risk (and therefore a much smaller position size), and stayed in the trade until he got his exit signal, he would have made the same monetary profit, but with many multiples of R less risk taken - and with a lot less stress!

For him, that was the light bulb or 'Aha!' moment.

To be able to follow your rules dispassionately, you have to have an 'emotional indifference' towards each trade. This can only be achieved by having your position sizing and risk per trade under control.

As it was, a single down day within the context of an uptrend that went on for the best part of four months was enough for him to override his exit rules.

Now in this case, the trade went in his favour, and he made money. But, given the position size he used on that trade, what if there had been a sudden price gap against him, which could have meant taking a loss far greater than what he originally risked? What sort of major damage could such an event have done to his equity?

Most inexperienced traders only think about the potential upside on a trade - how much money they can potentially make. They rarely worry as much about the potential downside. This is the opposite to how successful traders think, who have been able to stay in the game and make money over a number of years.

Fortunately, after that experience (and others where he lost money), he acknowledged the error of his ways, and accepted that he had to make changes in both his attitude to risk and his mindset. And he is now very rigid in his approach to risk, while spending an awful lot of time working on himself, his emotions and his mindset.

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