Risk control

When the stakes of a game go up, spontaneity and ease go out the window. When the stakes become dangerously high, people become stiff with tension and their performance deteriorates.

The edge that the winners have over losers in the financial markets is very narrow. If you start putting on trades whose size makes you tense, your performance will decline, and you will begin losing. One of the key goals of money management is to put your mind at ease by providing a safety net for your account. Intelligent money management is a reflection of healthy trading psychology. It allows you to concentrate on trading instead of worrying about losses.

Imagine what would happen if you came to my office and I offered you twenty bucks to climb on a conference table, walk its length, and jump off at the far end. You would probably be surprised, laugh, and collect the money. That smile would quickly disappear if I raised my offer to $2,000 but challenged you to walk not on a table but on a sturdy plank as wide as that table, connecting the roofs of two office buildings. Even if the day was very calm and windless, your legs would probably tremble and you would feel extremely tense. Physically, the task would not change, but the new offer would greatly raise your risk. That fear would prevent you from accomplishing your task.

As a trader sinks into worry or fear, he becomes more stiff, less adaptable, and more prone to making bad decisions. When you start playing for stakes outside of your comfort zone, you will begin losing money.

Trading is like walking on a high wire. To feel at ease, to feel playful, adventurous, and ready to explore the nooks and crannies of trading, you need a safety net. If you happen to take a wrong step, stumble and fall, the net will catch you. You’ll suffer no damage—just a minor scrape. Having a safety net will reduce danger and improve your trading performance.

One of the most common problems among traders is fear of pulling the trigger. I’ve heard enough people complain about it to devote an entire chapter in Entries & Exits about how to overcome it. In a nutshell, fear of pulling the trigger is the result of trading too large a size. If you had something like $20 riding on a trade, you would squeeze that trigger fast and hard, without hesitation. A trader afraid of pulling the trigger must take a break from trading and sharply reduce the size of his trades. He can build up that size only slowly and gradually.

The financial markets are infested with loud vendors whose vulgar advertisements imply that making money is easy if only you buy their merchandise. In fact, the market is a very dangerous place, where most traders lose money. An account that has lost half its value is as good as dead. You may fund a new account, but the old one is finished. Most accounts get demolished in one of two ways: by a shark bite or a piranha bite.

A shark bite is a single disastrous loss that mauls the account so badly that it has virtually no chance of recovery. A poor beginner who loses one-third of his equity would have to generate a 50% return on the remaining capital simply to come back to even. The victim of a shark attack almost always loses much more than money. He loses his confidence, becomes fearful, and cannot pull the trigger again. Whatever your trading method and style, you must do everything in your power to protect yourself from a shark bite.

Following the 2% Rule will keep any loss in your account to a relatively small, livable size.

A piranha is an aggressive fish that lives in the rivers of South America. Its main danger comes from the fact that it travels in packs.

A careless bull who stumbles into a piranha-infested river gets reduced to a collection of bones floating downstream. A smart bull would have fled after the first few bites.

The 6% Rule will define a series of losses after which you must exit the markets and wait on the shore.

The two pillars of money management are the 2% and 6% Rules.

Beginners are often fascinated by technical indicators. They tend to spend the bulk of their time looking at charts and trying to recognize patterns. Experienced traders know full well that psychology and money management are just as important. Professionals tend to spend almost as much time calculating money management angles as performing market analysis.

No comments: