Trading Psychology and Risk Management

Learning objectives

After studying this chapter the student should be able to understand:

  • Why to put stop loss and use optimal trade size
  • Qualities of successful traders
  • Do’s and Don’ts in trading
  • Trading along with trend
  • Choosing the Right Markets to Trade
  • Importance of Discipline in trading

 

 Introduction

It is generally noticed that when we invest or trade our focus is on potential gains rather than dwelling on possible losses. Traders are often so confident about their trades that they push back their minds and don’t think that something could go wrong. But in order to be successful trader, we must keep our mind open to the potential losses and we should know how to manage and control those losses.

 

If you are making huge profits in the market on a very small or average trading account,

it is most likely that you are not implementing sound money management. May be you are

lucky for one or two days that has earned you windfall profits. But you have exposed yourself to obscene risk because of an abnormally high “Trade Size.” If you continue trading in this manner, probabilities indicate that very soon you would land up with series of losses and you may lose your entire capital.

 

Trading, like every other business, needs to start with a certain amount of equity or “seed

capital”. Traders remain in business so long as they have this seed capital with them. Many

traders start and end their trading capital in just one month! By not controlling risk and by

using improper “Trade Size” a trader can go broke in no time. It usually happens like this;

they begin trading, get 5 to 8 losses in a row, don’t use proper position size and don’t cut their losses soon enough. After 5 to 8 devastating losses in a row, their funds become too small to continue trading.

 

Novice traders tend to focus on the trade outcome as only winning and therefore do not

think about risk. They don’t ask themselves, how much can they afford to lose on this trade

and hence they fall prey to the “risk-of-ruin” outcome. Failure to implement good money

management program will leave you subject to the deadly “risk of ruin” exposure leading

eventually to a probable equity bust.

Professional traders focus on the risk and take the trade based on a favorable outcome. Thus, the psychology behind ‘Trade Size’ begins when you believe and acknowledge that each trade’s outcome is unknown when entering the trade. You either adjust your “Trade Size” or tighten your stop-loss before entering the trade. In most situations, the best method it to adjust your “Trade Size” and set your stop-loss based on market dynamics.

During “draw-down” periods, risk control becomes very important and since good traders test their trading systems, they have a good idea of the probabilities of how many consecutive losses in a row can occur. Taking this information into account, allows the trader to further determine the appropriate risk percentage to take on each trade.

Let’s talk about implementing sound money management in your trading formula so as to

improve your trading and help control risk. The idea behind money management is that given enough time, even the best trading systems will only be right about 60% to 65% of the time.

That means 40% of the time we will be wrong and have losing trades. For every 10 trades,

we will lose an average of 4 times. Even certain trading set ups with higher rates of returns

nearing 80% usually fall back to a realistic 60% to 65% return when actually traded. The

reason for this is that human beings trade trading systems. And when human beings get

involved, the rates of returns on most trading systems are lowered. Why? Because humans

make trading mistakes, and are subject from time to time to emotional trading errors.

If we are losing 40% of the time then we need to control risk! This is done through implementing stops and controlling position size. We never really know which trades will be profi table. As a result, we have to control risk on every trade regardless of how sure we think the trade will be. If our winning trades are higher than our losing trades, we can do very well with a 60% trading system win to loss ratio. In fact with risk control, we can sustain multiple losses in a

row without it devastating our trading account and our emotions.

 Risk Management

Risk is there in every business and proper risk management is road to success for any business.

Equity trading is a lucrative business which is very rewarding but this reward is not risk free, as theoretically and practically risk free trade does not exist. Because risk is associated with the reward, it becomes essential to manage risk in order to protect one’s capital.

Risk management is very essential for trading as markets have potential to take back all life

time profits in just few bad trades. Risk managements help in preserving initial capital and

accumulated profits so that one can stay alive long enough in financial markets for wealth

creation, thus it provides biggest edge in trading.

 Components of risk management

 Stop loss

Stop loss is an integral part of risk management. Stop loss is an order placed to buy or sell

security once certain price is reached. It is basically designed to limit the amount of loss on

buy/sell position. In fact by placing the stop loss one is just closing the losing position and

limiting the amount of loss which can increase beyond imagination.

 

 Analyze reward risk ratio

Before initiating a trade, the trade should analyze reward risk ratio. On a conservative basis

if the said ratio is less than 1.5 then one should not initiate the trade.

 Trail stop loss

Initially stop loss is placed to protect one’s capital on a losing trade, but once the trade is

in profit stop loss should be so moved that trade is at zero risk even if trailed stop loss gets

triggered.

 Booking profit

Profit is the only goal for which we all trade. But at the same time profit is profit only when it is realized otherwise its notional profit. Hence one should book profit at predefined target levels and one should not be carried away by one’s emotions specially greed when prices are near to predefined target levels.

 Use of stop loss

A trader should always put Stop Loss and trade a fraction of his capital. It is very important for the trader to have sound knowledge in the area concerned and should be comfortable with the trading system. He should be aware that it is possible and inevitable to have a losing streak of five losses in a row. This is called drawdown. This awareness will help the traders prepare as to how to control risk and choose their trading system.

What we are striving for is a balanced growth in the trader’s equity curve over time.

 Qualities of successful traders:

  1. Always use stops
  2. Trade size should be determined on the basis of trading account equity, and stop loss

price for every trade.

  1. Never trade more than 10% on any give sector
  2. Never exceed a loss of 2 to 5% on any given trade
  3. Always trade with risk capital, money you can afford to lose.
  4. Never trade with borrowed money and don’t overtrade based on the time frame you

have chosen to trade

Golden rules for traders

Want to trade successfully?

It is very important to choose good positions over the bad ones. Poor trading sense leads

to a heavy loss of both the confidence and money. Without a system of discipline for your

decision-making, impulse and emotion will undermine skills as you chase the wrong stocks at the worst times.

Many short-term players view trading as a form of gambling.

Many short-term players without planning or discipline jump in the market. The occasional

big score reinforces this easy money attitude but sets them up for ultimate failure. Without

defensive rules, insiders easily feed off these losers and send them off to other hobbies.

Technical Analysis teaches traders to execute positions based on numbers, time and

volume.

This discipline forces traders to distance themselves from reckless gambling behavior. Through detached execution and solid risk management, short-term trading finally “works”.

 Do’s and Don’ts in trading:

The science of trend allows you to build systematic rules to play these repeating formations

and avoid the chase:

  1. Forget the news, remember the chart. You’re not smart enough to know how news

will affect price. The chart already knows the news is coming.

  1. Buy at support, sell at resistance. Everyone sees the same thing and they’re all just

waiting to jump in the pool.

  1. Don’t chase momentum if you can’t find the exit. Assume the market will reverse

the minute you get in. If it’s a long way to the door, you’re in big trouble.

  1. Trends test the point of last support/resistance. Enter here even if it hurts.
  2. Trade with the TICK not against it. Don’t be a hero. Go with the money flow.
  3. If you have to look, it isn’t there. Forget your college degree and trust your

instincts.

  1. The trend is your friend in the last hour. As volume cranks up at 3:00pm don’t

expect anyone to change the channel.

  1. Avoid the open. They see YOU coming sucker
  2. Bulls live above the 200 day, bears live below. Sellers eat up rallies below this key

moving average line and buyers to come to the rescue above it.

  1. Price has memory. What did price do the last time it hit a certain level? Chances are it

will do it again.

  1. Big volume kills moves. Climax blow-offs take both buyers and sellers out of the

market and lead to sideways action.

  1. Trends never turn on a dime. Reversals build slowly. The first sharp dip always finds

buyers and the first sharp rise always finds sellers.

  1. Bottoms take longer to form than tops. Greed acts more quickly than fear and causes

stocks to drop from their own weight.

  1. Beat the crowd in and out the door. You have to take their money before they take

yours, period.

 

 Rules to Stop Losing Money

  1. Don’t trust others opinions – It’s your money at stake, not theirs. Do your own analysis,

regardless of the information source.

  1. Don’t break your rules – You made them for tough situations, just like the one you’re

probably in right now.

  1. Don’t try to get even – Trading is never a game of catch-up. Every position must stand

on its merits. Take your loss with composure, and take the next trade with absolute

discipline.

  1. Don’t believe in a company – Trading is not investment. Remember the charts and

forget the press releases.

  1. Don’t seek the Holy Grail – There is no secret trading formula, other than solid risk

management. So stop looking for it.

  1. Don’t forget your discipline – Learning the basics is easy. Most traders fail due to a

lack of discipline, not a lack of knowledge.

  1. Don’t trade over your head – Concentrate on playing the game well, and don’t worry

about making money.

  1. Don’t chase the crowd – Listen to the beat of your own drummer. By the time the

crowd acts, you’re probably too late…or too early.

  1. Don’t trade the obvious – The prettiest patterns set up the most painful losses. If it

looks too good to be true, it probably is.

  1. Don’t ignore the warning signs – Big losses rarely come without warning. Don’t wait

for a lifeboat to abandon a sinking ship.

  1. Don’t count your chickens – Profi ts aren’t booked until the trade is closed. The market

gives and the market takes away with great fury.

  1. Don’t forget the plan – Remember the reasons you took the trade in the fi rst place, and

don’t get blinded by volatility.

  1. Don’t join a group – Trading is not a team sport. Avoid acting on messages, fl ashes and

fi nancial TV. Your judgment may be more correct than all of them put together

  1. Don’t have a paycheck mentality – You don’t deserve anything for all of your hard

work. The market only pays off when you’re right, and when your timing is really, really

good.

  1. Don’t ignore your intuition – Respect the little voice that tells you what to do, and

what to avoid. That’s the voice of the winner trying to get into your thick head.

  1. Don’t hate losing – Expect to win and lose with great regularity. Expect the losing to

teach you more about winning, than the winning itself.

  1. Don’t fall into the complexity trap – A well-trained eye is more effective than a

stack of indicators. Some time Common sense is more valuable than a complex set of

indications.

  1. Don’t confuse execution with opportunity – Overpriced software won’t help you

trade like a pro. Pretty colors and flashing lights make you a faster trader, not a better

one.

  1. Don’t project your personal life – The outcome of your trade is defi nitely likely to get

affected by the situation at your home. Get your own house in order before playing the

markets.

  1. Don’t think its entertainment – Trading should be boring most of the time, just like the

real job you have right now If one could sum up the single most important aspect of successful trading it would be to stick

with the trend as much as possible.

“The Trend is your friend until the end when it bends.” Anonymous

If you have been around trading for any time at all you’ve probably encountered that quotation a thousand times by now. But in all those times have you ever really tried to understand what this well worn expression is saying to you?

Whoever was the fi rst to say, it knew the secret to making money in the markets. Trading

with trend is not just another axiom that rolls off the lips of traders, but it is the very core

of successful trading. As almost any successful trader will tell you, there are infi nitely better

opportunities to trade with the trend then against it.

So, if it is such a commonly accepted truism among traders that the best way to make money

in the markets is by trading with the trend, why is it that so many traders chose to take

positions against the predominant market direction?

I suppose one reason is that within each of us is a rebel. It is part of human nature to go against

the *crowd*. Our society embraces individualism and as a result everyone strives to be an

individual. Sometimes this is interpreted as doing the opposite as everyone else.

There is something romantic about being the underdog. Everyone roots for the underdog.

Traders have even coined the term *contrarian* to describe the strategy of trading against

the trend.

Now does that mean that you will never lose money by trading with the trend? Of course not!

Every trend ends and reverses eventually which will stop you out. Furthermore markets make

regular pullbacks as a part of an ongoing trend which could stop you out prematurely.

You should always trade with the trend until it hurts. You should follow the trend until you can

not possibly conceive how the market could go any higher/lower. And then you should trade

with the trend some more. One must Paper trade it. I think you’ll be pleased with the results.

One of the things that the majority of folks fi nd most challenging about trading is determining

which is more important: a good entry or a good exit?

As has been pointed out so many times before, the three components of good trading are

market analysis, money management and mental attitude.

As every experienced trader knows, market analysis is the easiest part to learn. However, that

by itself only turns you into a good PAPER trader!

There is a world of difference between paper trading and real trading. And the difference is

the emotional impact trading has on us, when we trade with real money.

Emotions make a trader hang on to a losing trade, because he has the hope that the market will

turn around and get him back to break-even, causing him to ride a bad trade into oblivion.

Emotions will keep a trader out of entering a perfectly good trade, because he is afraid of this

being a losing trade.

Emotions make a trader exit a good trade, right after he entered, because the normal jiggles

in price make him doubtful of his analysis and afraid of losing on this trade, thus making him

miss out on what could be a long ride.

Trades are rarely entered at the low point of a V-shaped bottom. The great majority of our

trade entries are followed by some form of ‘chop’, right after entry.

This applies to both position trades and day trades. The time frames may be different (days,

in case of a position trade, and minutes, in case of a day-trade), but the principle is the same:

What looked like a perfectly well thought-out trade before the order was placed can turn into

a struggle with fear and doubt.

Once these emotions surface, it becomes diffi cult to stick with the original plan. Many traders

then take the easy way out, by escaping to the safety of being on the side lines. And there

goes another good trade without them!

A carelessly placed entry almost always results in such misery.

On the other hand, take those incidences when a buy was made right at the low. What a nice and

relaxed feeling, when the market goes in the right direction immediately after entry!

So what, if there are some wiggles! There is a profi t, even if it’s only a small profi t. Now it is

so much easier to keep a cool head and make the right decision.

Therefore, it is my belief that a trader should strive to perfect his entry techniques fi rst, and

worry about the exit later on.

Here are some tips for the newcomer, aimed at relieving trading-stress:

Use stops! Many traders trade without stops. They argue that they don’t need to place stop

loss orders because they are closely monitoring the market.

This may be so, but the intense monitoring required, and the ever present possibility of a

quick adverse price move, create unnecessary additional stress. A well placed stop can do a

lot to relieve the tension associated with a new position.

Keep your positions small! Many newcomers try to make a quick killing by using positions that

are too large for their account, or trading a stock that’s too volatile for them. A sure way to

increase the stress level!

Accept yourself for what you are! There are many ways to trade the markets. But we all have

different personalities, and many trading styles simply don’t fi t our personality and emotional

set-up.

Some people are natural long-term investors; some people are natural day-traders. Find out

what suits you best, and then throw away those books that try to turn you into a person you

can never be.

7.4 Choosing the Right Markets to Trade

An often overlooked part of trading is choosing the right markets to trade. Most traders do

not pay too much attention to the mix of markets they follow. New traders are sometimes at

a loss as to how many markets or sectors to trade and which ones to follow. It is a common

misconception that you need to follow a lot of stocks to be a successful trader. This is not true.

For most traders, choosing six to eight stocks to follow should be adequate. It is important

to allow some diversifi cation among the markets you follow however, so as to allow for the

maximum number of trading opportunities.

You would not want to choose all power stocks to follow, or all grains if trading in commodities.

By taking one or two picks from each category you should have enough of a cross section to

catch most of the opportunities within that category.

 

7.4.1 Importance of discipline in trading

Overtrading is the biggest reason for failure of people in trading While there is no defi nitive

rule for how many times you can (or should) trade, new traders should be especially cautious

not to overtrade. Industry statistics show that 90% of new traders will not make it to their fi rst

anniversary. Why? Overtrading is one factor that has been identifi ed as a defi nite ‘no-no’.

So why do traders overtrade?

  • Traders overtrade because of the reason that they are hooked on the rush that comes

form being in the markets

  • Some overtrade because they feel they that will miss a golden opportunity if they don’t

trade.

  • Some traders overtrade because their system does not have specifi c enough entry criteria

to keep them out of bad trades.

  • Many traders in a hurry to start trading don’t wait for a good opportunity but start trading

with a fi rst trade that looks good.

  • Some traders overtrade because they feel that the more they trade, more the money they

will be able to make.

This is the real secret in making more money with your trades: learning to identify the best

market opportunities.

There are three positions that a trade can have in the market namely: long, short or fl at. But

the trader’s don’t realize this. Many of them feel that they have to be constantly in the market

for which they need to acquire either a long position or a short position. It is equally important

to recognize that the third option, being fl at, is as legitimate a position as the fi rst two.

Being fl at allows you to watch the market set up so that you can best take advantage of

the market when it is ready. This is what traders mean when they tell you *not to chase the

markets.*

It is important to learn to wait for the markets and let them come to you. Then your job as a

trader is to be ready for them.

Buy, sell, or stand aside. Just make sure it’s the right decision at the time.

There are many methods to build superior trading habits. Good trading habits will make

trading a part of routine, rather than a task. Getting in the habit of doing everything exactly

to plan will boost trading profi ts, marking one more step in the path to fi nancial freedom.

  1. Trading discipline – One’s own trading plan is very important to success. It should be

followed strictly. Emotions have no place in trading and it could easily lead to losing of

money. Proven techniques and strategies should not be edited for any reason; follow the

plan and let it work for you.

  1. Understanding risk – Difference between gambling and investing is what is called as

managing risk. Profi table traders can quickly calculate how much of a drawdown they are

willing to incur before cutting a position. It is important to have a plan for pruning losses

and minimizing the damage of drawdown.

  1. Stick to your niche – Niche trading is considered to be the best strategy to remain

profi table. Sticking to an area in which one specializes is the best way to minimize losses.

If one is best in high volume trading, then only trade during periods of high volume.

Finding your trading niche will help you to become more a more effi cient trader.

  1. Look at every time frame – Even when trading short 5 minute ticks, it is important to

evaluate all timeframes for market data. It just might happen that a 100 day moving

average is acting to support your position. You’ll never know this unless you take the time

to study all timeframes rather than just a few. Long term trends can and do impact short

term trading positions. Day traders are more susceptible to trading in only one timeframe

because of how time-sensitive their investments are. Swing traders are probably used to

checking multiple timeframes for entry points.

  1. Trading is affected by emotion – It is diffi cult to get away with the trading. Holding

open positions can increase the amount of stress. Day traders should try and limit the

exposure and keep the stress at lower level.

  1. Trade as your capital allows –High levels of margins can be easily exceeded by the

day traders that greatly exceeds there trading capital. Exceeding the credit limit can

be very dangerous and it can accumulate losses as fast as gains. Momentum trading

with many different entry points can end up in costly mistakes if your account becomes

overextended.

Even the best traders in the market have trading sessions that are less than optimal. Human

nature dictates that we make mistakes, and trading the stock market is no exception.

Subsequently, there is always room for improvement, whether you are a novice trader or a

seasoned veteran.

  1. Stick to your Guns – Running from the market is no solution. One should try to stay in

the game and earn profi ts. Sticking to the trading plan and enacting trading discipline are

the best ways to produce profi ts.

  1. Set stop losses and take profi ts – The most profi table trading is one in which we

“Set and forget”. Once should remember to place exit along with placement of trade.

Technical analysis will tell you the best price or selling (near resistance) and the best

place for buying (near support). Support and resistance points are the best places to put

limit orders.

  1. Don’t watch minute to minute – The minute to minute movements should be avoided

by the traders. It is diffi cult to have a potentially profi table trade after having minute to

minute movements. There is no reason to get out of a trade for quick profi ts if you’re

in for the long haul. Small ups and downs create temporary stress and can reduce

swing traders to day traders. Niche trading works because you’re specialized in your own

area.

  1. Eliminate high probability trading – You wouldn’t expect to make consistent profi ts

at the roulette wheel, and you shouldn’t do the same with your investments. The active,

professional trader only takes quality trades opposed to quantity of trades.

  1. Accept that full-time day trading is rough – It is very diffi cult to trade on a full time

daily basis. The ups and downs of full-time day trading are very stressful. Stress will

make you think differently and trade differently. A professional trader will need to fi nd

ways to vent their frustrations as bad days do happen to the best of traders.

  1. Don’t get attached –one should not be too attached with the stock. Investor should be

ready to dump it off when the price is right.

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  1. Pick swing traders or day traders – Know exactly what kind of trader you want to be.

It is diffi cult to be very good at swing trading while following short term movements of

day trading. Defi ne what kind of strategy you want to follow and stick with it.

  1. Talk to other traders – Communicate with other traders and share their experiences.

Aim should be to get trading down to a point where it comes naturally to you.

*****

New terms

Drawdown: A Drawdown is the peak-to-trough decline during a specifi c record period of an

investment, fund or commodity. A drawdown is usually quoted as the percentage between the

peak and the trough.

Test: In technical analysis, it is when a stock price approaches a support or resistance level

set by the market. If the stock stays within the support and resistance levels, the test is

passed. However, if the stock price reaches new lows and/or new highs, the test has failed.

Trend: The general direction of a market or of the price of an asset is known as a Trend.

Trends can vary in length from short, to intermediate, to long term. If you can identify a trend,

it can be highly profi table, because you will be able to trade with the trend.

Holy grail: As the community of traders has evolved, the “Grail buy” has been nicknamed

“the dip”, implying a place where a buy may be set up. The “Grail sale” has been nicknamed

“the ding”, implying a place where a short sale may be set up. This refers to the Holy Grail

technique. The key is to buy pullbacks in an established uptrend, or sell bounces in an

established downtrend and avoid trading ranges.

Stop loss: A stop loss is an order to buy (or sell) a security once the price of the security

climbed above (or dropped below) a specifi ed stop price. When the specifi ed stop price is

reached, the stop order is entered as a market order (no limit) or a limit order (fi xed or predetermined

price).

Contrarian: One who takes a contrary view or action, especially an investor who makes

decisions that contradict prevailing wisdom, as in buying securities that are unpopular at the

time.

*****

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