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Controlling Risk, Cutting Losses and Newsletters

Risk Management
Written by Andy

What’s your Problem? Let Me Guess!

You’re not alone if you feel you need to improve your trading. As many as 90% of would be traders find they can’t make a profit and give up in the first six months of trying. The general issues you face are the prospect of easy money, the excitement, and the lack of reality. Each of these has its effect on you. Imagine that someone offered $1 million for the fastest lap on a race circuit. You would get lots of people applying to try, but how many would be well prepared? In fact, how many would fail to complete the lap? Wouldn’t you like to be well-prepared?

We’ve covered in this brief report some of the reasons that so many fail. One of the main ones is a failure to control the risk, and this stems from a lack of discipline, or from a lack of a trading plan or knowing what to do. Tied into this is using too much leverage with derivative trading. Let’s just run through the major issues.

Controlling Risk

In any other endeavor, you would check that you had minimized the risk. Say you wanted to go motorcycle racing, I expect you would check the machine out, making sure it was tuned up and that the brakes worked. Yet in trading novices take much less care to ensure they are equipped to face the challenges. Often it’s the idea of “easy money” that started the thought in first place.

‘Risk management is essential to minimise the size of your losses. Initially, our risk profile was 3% of our trading float and this figure will continuously reduce to a target of 1.6%, as our float grows. This is a risk management technique that works for us based on our float size. We never break the rules when it comes to risk management. Anyone that tries to out-smart the market will face big problems’ – Shaun and Sonya Lloyd – Australian CFD Traders

Yet many beginners don’t have a real plan for controlling risk, because they concentrate on the upside of their trading, and don’t consider the downside thoroughly enough. They read the books, it seems straightforward enough, so away they go. But the point is, if you don’t control the risk rationally you probably won’t be trading for very long before running out of money.

Often it’s a lack of discipline that’s the problem. You may even know the best advice, but in the emotion of trading you tend to ignore it. Fear and greed are often cited as the emotions to watch out for, and they are powerful, but that’s to assume that a human being is two-dimensional. You will fi nd many more different emotions play on you where the real money is at risk.

Cutting Losses

The problem I always had was quitting a losing position quickly, particularly if the trade had just been placed. It just doesn’t feel right to admit you are wrong so quickly, and it certainly goes against your normal instincts. But unless you can do this, you won’t succeed at trading. Capital preservation is more important than the possibility of profit. With correct trading, the profit will come.

One way to think yourself out of this problem is to regard each losing trade as another step to your profits. Be eager to cut your losses. Say your trading plan tells you that on average you will have six winning trades for every ten you place. That means you need to make four losing trades. Each time you close a losing trade you progress your plan.

Yeh, right. But get used to it. I remember well ‘doubling down’ on one position I had. If it’s worth buying in the first place, then if the price falls it’s a better deal, isn’t it? I wasn’t thinking, as this was a recommendation from one of the financial newsletters I subscribed to, and I abdicated my responsibility to their “expert opinion”, which even included the advice to increase the position when the value fell.

Following Newsletters

This situation went well, as the shares kept dropping until they finished up at 2 cents a piece, and I think got de-listed too. I certainly didn’t get anything out of them, as they weren’t even worth the commission to cash in once I’d got my head around the fact that they REALLY weren’t going to recover. Why do I say it ‘went well’? Because the worst thing that can happen is that you trade badly and the market saves you. I should never have (and you should never) doubled down, and if I’d been rescued by the price coming up, it would have reinforced a bad action which I’d be likely to repeat. As it was, I learned the lesson.

That was a subscription newsletter, but another danger is the newsletter that you receive, either in an e-mail or in the mail, that you didn’t ask for. Often they look authoritative and contain extensive details and ‘research’ about a small company ‘expected’ to double or triple rapidly. Again, get caught once, and you would be wise to learn the lesson. While such unsolicited correspondence might occasionally give you a pointer to a stock that you may wish to independently research for your portfolio, usually it is a disguised advertisement, and part of a ‘pump-and-dump’ scheme.

Here’s the trick. Look to the end, where there is usually a mass of small print that proclaims the letter is not a recommendation, does not constitute an offer to trade, and the sender was compensated $25,000 or more for the work. I’ve often thought this would be a good line of work to be in, but considering how I feel about such deceptive letters, it would be very hypocritical of me!

Maintaining Discipline

A lack of discipline is failing to do what you should do. It might be failing to cut your losses on a losing trade, but it might equally well be taking your profits prematurely so you miss out on some of the move, or perhaps not even taking a trade after a succession of losses, or failing to “pull the trigger”. You can have the best trading plan in the world, but if you don’t stick to it the results are questionable.

What often happens is that you know that you made the right move, but it doesn’t work out. You try and rationalize the reason for it rather than just accepting it. The more intelligent you are the more you are open to this trap. Why it happened is irrelevant, you must just react, accepting the facts, and move on. The markets are bound to frustrate you again and again, but the trick is not to frustrate yourself. You can control your reaction to the markets, but you cannot control the markets.

Richard Dennis, one of the recruiters for the “Turtles” in the 1970s called doing what you’re supposed to when there are 1 million other reasons to do something else “doing the hard thing”. The Turtles were taught to “do the hard thing”, and that helped make them some of the most successful traders in history. Second guessing a trading decision is one of the simplest things to do, and one of the most destructive to your trading career, and if you find yourself doing it frequently you need to develop a new approach.

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