I’m a very good example of what you should not do as a trader. I’ve been trading for almost 15 years and have made every mistake imaginable to mankind (womankind?) in this arena. Yet I’m still standing because I have learned from my mistakes (well mostly) and, without a doubt, one of the most important lesson I’ve learned is controlling risk.
In September 2008, I had a hedge fund manager trading my account using Iron Condors. I had become complacent because this account was making a nice income for me each month, which lulled me into that very bad place called, “It will continue forever.” We all know this place and we all know it’s not a place we inhabit for long. It will kick you out quite unceremoniously, usually with a huge loss.
I was aware of the risk this manager was taking on but I refused to acknowledge it. I refused to sit down with him and tell him that 70% of the account at risk in one trade was not acceptable. I mean, what did I know? He was the professional. I let go of the fact that, although he was the professional, I was the owner of the account.
This account lost a little bit in September but he assured me we would get it back and that “I had to accept some losing months.” I was OK with that and knew this to be true (I thought I was kicked out of the “It will last forever” place with a relatively small loss).
October 2008 arrived and the full impact of the financial crisis was upon us. People were jumping out of windows (OK not that bad) but things were looking pretty darn bad. The DOW was
making 600-700 point swings up and down and we just didn’t know where it was all going to stop. The options in my condor were set to expire at the end of the month and I was starting to get this sick feeling that I would have to live through the worst-case scenario where 70% of the account would be vaporized. The day the options in the condor were set to expire was upon us and I was looking at two scenarios. 1) If the S&P traded up instead of down I would be OK, I would take a loss but not the MAX loss. Or 2) If the S&P traded down I would take a max loss. Well, it didn’t trade up, it traded down and 70% of the account vaporized. Mr. Market loves to show you who’s boss and the S&P traded up the following day, one day too late. Hey, its only money.
Making Money in the Market is Very Difficult
Making money in the market is a very difficult, energy-draining endeavor. And since truly great traders are never out of the market for extended periods, it’s common sense that there are times when you are not making money. How to handle these periods psychologically is another discussion but handling them financially does demand we learn how to control the downside during these periods.
To be a successful trader means you have to have a flawless understanding of the risks that are inherent in this business. The harsh fact is that most traders are not conscious of these risks.
Each transaction is a “tradeoff” between profit and risk, right? You take on more risk and your profit potential grows and vice versa, you reduce risk and your profit potential drops. Doesn’t it follow then that risk is the “currency of trading?” Just like money, you relinquish money for stuff and you get money for doing stuff.
First and foremost on a trader’s mind should be capital preservation (those dreaded words). Curse if you will but if you want to trade, capital preservation should be your most vital consideration. If you make it a priority and institute some very simple rules to achieve it, you will not only become a better trader but you’ll live through the drawdowns to see another day.
At times you’ll curse these rules and think you missed the gravy train that everyone else is riding because capital preservation is not necessarily conducive to maximizing returns during periods of peak market opportunities. However, it more than makes up for it when you head for the tunnel called financial ruin when you are ready to throw up your hands and call it quits.
You need to look at capital preservation, or risk management, as an investment that will cost you money. The return you get on this investment is the peace of mind that you’ll be OK no matter what Mr. Market throws at you.
6 Risk Rules to Live By
Here are six rules for controlling risk to make part of you before you start trading, or even if you’re well into your trading career. I wholeheartedly recommend they be part of your trading persona.
1.Have a plan and stick to it. I used to write technical analysis articles for a day trading website and at the end of every article I would write, “Plan your Trade and Trade your Plan.” I haven’t always stuck to that motto but it has been an underlying force my entire trading career. For me, a plan is an algorithm – a set of rules coded so a computer will do my scans and tell me which stocks set up for trading the next day. No emotion involved, no thought on my part, just do it. Have you ever heard of High-Frequency Trading (HFT)? Here is how Wikipedia explains it, “High-frequency trading is quantitative trading that is characterized by short portfolio holding periods. All portfolio-allocation decisions are made by computerized quantitative models. The success of high-frequency trading strategies is largely driven by their ability to simultaneously process volumes of information, something ordinary human traders cannot do. Specific algorithms are closely guarded by their owners and are known as ‘algos.’” Why not use successful algorithms but hold for days instead of seconds or minutes. It’s not HFT but it’s successful.
2.Fight for every fraction of a point in trade execution. Another title for this point is, “use limit orders to ensure you get the price you want.” No fighting just get me filled at the price I want or no thanks, I’ll find another trade. Every trade QiT signals uses a limit order – bar none.
3. Don’t trade without an exit plan. A big way to controlling risk is to have an exit plan before putting on your trade. QiT’s exit plan is built into the algorithm and has been tested thoroughly to ensure it’s the most profitable exit plan possible.
4. Don’t operate outside your account limits. I have a real-life example of this rule. I wanted to test an option strategy and was just about to put on a “test” trade when I thought, “Hey wait a minute. Just where does this fit into my portfolio”? I certainly have the money in the account because I am almost never fully invested but from which account do I take the funds? Do I take it from the IRA or the margin? I don’t have an account set aside for “testing” so the answer is it doesn’t fit into my plan. Now if I do the due diligence and recognize this option strategy is viable, one that will help my monthly return, I can allocate some of my current funds for testing. But, of course, after due diligence is done.
5. Make sure you continually optimize your strategy. Markets are changing constantly so you need to as well. Additionally, how do you know when it’s time to drop the strategy, or at least tweak it? QiT is constantly optimizing its algorithms to ensure the best possible set of parameters.
6. Take on more risk when you are up and less when you are down. This can be as simple as increasing the number of shares when your account is up and less when it is down, in other words, a percentage of your account for each trade.
Controlling risk is hard because we all think we give it the respect it deserves but I would like to propose that maybe we don’t. I recognize I didn’t until I learned an extremely hard lesson.
Maybe you can learn from me?
Plan Your Trade and Trade your Plan
ALWAYS FOLLOW THE RULES
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