Trading and Risk Management
Once we have achieved our goal of coming up with a trading plan that can be expected to be profitable over time, this alone is not enough, as we also need to be aware of the need to manage risk.
These two goals are connected, and we need to seek to strike the right balance between the two. If we only traded an extremely small percentage of our portfolio at once, for instance only risking $100 per trade with a $100,000 portfolio, and our trading plan was a sound one with positive expectations, we will have taken risk virtually out of the picture, but that’s not the goal here.
In this case, we would have given far too much weight to risk management and this would end up severely limiting our overall potential returns from our trading.
If we put our whole $100,000 on the line in a highly leveraged trade where a minor movement against us would wipe us out, but we could increase the value of our portfolio several times if the trade worked out, we may be maximizing our profit potential but the risk here would be way too high.
Less experienced or accomplished traders as well as almost all investors, who really don’t have developed trading skills of even the most modest means by successful trading standards, tend to pay less attention to risk than is warranted. Accomplished traders end up learning the importance of risk management, often through hard lessons, and the lessons that are learned is that it is very important to look to strike the right balance between risk and return.
We don’t want to put too much emphasis on either, although if anything, we should be seeking the path that will steer well clear of the type of drawdowns in our portfolios that will cause too much harm.
This isn’t really about losing all your money, and with a profitable plan that should never happen, or anything even close for that matter. The real risk is getting into a hole that will take too much to dig out of.
For instance, if one loses half of one’s portfolio, they have lost 50%, but they will need to deliver twice that in gains to get even again, where you have to now double the value of your account. Losses that are incurred are always going to take more of a gain to compensate for, so the goal then needs to be to limit this drawdown exposure so that you don’t get yourself into a spot which will be unduly difficult to get even with.
If one is trading with an unprofitable expectation though, this changes things, as the expectation is that one will suffer losses over time, and we might think that risk management is less important. The opposite is true though, and risk management is much more important in this case, even to the point where we might want to say that the trader should not be risking anything here, and perhaps just doing simulated trading.
There is a lot to be said about trading with real money though, so that’s a reasonable choice, although the amount risked should be kept to a minimum, perhaps even more conservative than our example of risking $100 per trade with a $100,000 portfolio.
With a negative expectation, being more conservative means limiting your losses more, and you also want to stay in a good position should you learn enough to turn things around later and become profitable overall. It’s far better to arrive here with most of your money left than most of it or even all of it gone, where you’ve paid a high tuition but are left much less able to take advantage of what you have learned.
How Traders Become Profitable
Price movements of financial assets are predictable in various time frames, starting with the fact that if you look at long term charts of things like the stock market you can see that over the very long run prices do go up, even net of inflation.
This happens in the very long term, and we can also spot patterns in the long term, the medium term, the short term, and even the very short term like one second bars on a chart. The longer the time frame, the longer the cycles will be, and prices do oscillate in a similar way on any time scale, which we call the fractal nature of the market.
This is all driven by trading behavior itself, where even the moving prices themselves, the momentum, helps drive further momentum. if the price of something is increasing, more people will be tempted to buy, and more people will be tempted to sell if the price is decreasing. There are of course points where the price moves up enough that people start selling more, reversing the trend, or start buying when the price declines to a certain point.
While prices do strive toward a certain equilibrium, along the way we see what is called overbuying and overselling, where the momentum of the trading itself will drive the price higher than its equilibrium, causing it to adjust the other way for a time, and then this adjustment may need to readjust by reversing again.
These patterns occur at all time frames, where if you are seeking to trade on a longer timeframe you will hold through the minor fluctuations and only trade the larger ones, or if you are trading on a shorter timeframe these more minor trends will drive your trading decisions.
The goal of trading is to seek out profitable patterns in movements in price, to seek to be on the right side of the trends that you are seeking to trade, with a certain tolerance level which would indicate that the trend is over and a reversal is more likely.
A simple example of this would be entering and staying in a trade if a certain moving average is moving in a certain direction, and exit when the moving average reverses. There are many variations of this technique and many indicators you can use, including just trading on price itself, with a trailing stop for instance, where if the trade moves away from you by a certain amount at any given point in time you will exit.
While we never really know how any potential trade will end up, which would require certainty in the future price movement of something, which we certainly don’t have, what we seek is to employ strategies that will yield more profit than losses if executed properly.
Proper Execution is Also A Major Goal in Trading
Trading involves more decision making than investing, and the more decisions that a trader has to make, the more important proper execution becomes. It is one thing to have a profitable trading plan, but it can be a completely different matter to be able to execute it properly.
Newer traders often don’t realize how important or how challenging this can be, where one may deviate from what may have been sound trading ideas by failing to execute them properly.
For instance, one may enter a trade that isn’t quite suitable due to perhaps not seeking a good trade setup, or may not enter a position that would be profitable overall due to fear of the trade not working out.
One may exit a position too soon, wanting to overly protect profits, or overly protect against risk, or one may exit a position too late, hoping too much that it comes back or not wanting to book the loss.
The psychological part of trading plays a big role in one’s success, such that no matter how skilled one may be in picking entries and exits, if one cannot perform properly and execute the system, it won’t matter.
There are therefore several main elements of successful trading, which are looking to maximize profit, do so while properly managing risk, and coming up with a plan that seeks the ideal balance between these two competing factors and being able to execute the plan properly.
This all can be accomplished, and quite well, although this is all more challenging than many people think, and does require one to develop the sufficient skills to be able to consistently put this all together.