Monday, 30 July 2012

Golden Rules to Manage Risk and Uncertainty

I could start talking about the same trading and risk management rules that everyone else does.

1. Have clear entry and exit signals - always know why you're entering and exiting a trade

2. Have stop losses in place to cut your losses

3. Have a plan to take profits along the way

4. Diversify your trades - don't put all your eggs in one basket

5. Be disciplined - write your trading plan down and stick to it

But I'm not going to do that...

Well, don't get me wrong, I think these are ALL great rules, and are very important. But I'll bet at some time, at some point you've probably read about them anyway!
What I'd rather do is get deeper in the detail.What I mean is, what is it that stops us from following these simple rules?

Usually it's our mindset. It's our emotional reactions to situations involving IRRATIONAL

FEAR, and sometimes GREED that stops us from rationally following the 5 basic rules above.

I mean, if we could all act like robots and just coldly follow our own trading rules to the letter, without getting caught up in the emotional roller coaster of the markets, we'd probably do very well.

But then again, we wouldn't be human...If we want to become good (human) traders, we have to learn to manage our mindset.

So, let's look at my 5 Golden Rules.

1. Overcome your fear of risk

If you avoid taking risks because you are too fearful, that costs you opportunity. As they say... "Nothing ventured, nothing gained." And trading involves risk. That's a fact. So, how can you overcome your fear?

The key is gaining a sense of self control...There are 3 main kinds of fear:

a) Novelty fear - this is the fear of the unknown

b) Irrational fear - otherwise known as 'phobia'. Irrational fears are fears that are out of proportion to the actual threat being faced

c) Rational fear - this is the kind of fear we should not be afraid of! This is the type of fear that is in

proportion to the actual threat being faced If you learn more about what the risks actually are, then this helps you to overcome the Novelty Fear... because you conquer the unknown through knowledge. Then, if you learn how to manage
your risks intelligently, you can start to feel like you know what level of risk you're going to be willing to take in any given situation. In other words, you can have an appropriate level of Rational Fear. If you know the risks you're taking, and you take the protective measures you need in order to feel comfortable with that level of risk... that's rational.Now, when it comes to Irrational Fear... well, mastering that can be a bit more tricky. Some professional counselling can be a good idea in that kind of situation. Irrational fears can often be addressed through Neuro-Linguistic programming (NLP), or using therapy techniques such as 'Systematic Desensitisation' or 'Flooding'.With 'Systematic Desensitisation' you repeatedly expose yourself to the fear bit by bit in order to increase your level of tolerance to it. So, experiencing little losses in the context of decent profits as well, will help to reduce your sensitivity to the fear of loss. With 'Flooding', you expose yourself to the fear to such a degree that the emotional response mechanism is 'flooded' and the irrational fear is disabled.
So, while big losses really hurt, if you keep on trading and find your way back into profit, subsequently the prospect of a big loss may not strike terror into your heart anymore.Great traders all have to learn to live with and manage their fear. They learn to refine their fear so that it ONLY consists of Rational Fear.The best way to do this is to learn to understand the risks better, discover your own comfort levels when it comes to taking risks, and trade within those boundaries.But, what happens if you experience a big loss?FEAR can grip a lot of people who have experienced a loss. They can get hesitant to get back into the
saddle. But if a trading opportunity is good... then trade it! Because you won't trade your way back into profit by being reluctant to ever take a risk again.
Take the lesson you learnt from losing the trade, and then trade again.
Analyse where you went wrong. Take appropriate steps, adjust your process to try and make sure you won't make the same mistake again... but keep on trading!5 Golden Rules to Manage Risk | 3

2. Actively seek the truth and face it

If you put your head in the sand and avoid facing the reality of the risk, and you have already exposed yourself to the trades you have already put on, and you hang onto the need to be RIGHT... This is what usually causes the all-too common mistake of letting the losses get too deep before you cut them. You know that famous question: 'Do you want to be right, or do you want to be happy?' Well, the trading equivalent is: 'Do you want to be right, or do you want to be profitable?' If you really want to be profitable, you need to let go of your need to be right. In fact, even before you put a trade on, you should ask yourself this: 'What would be the warning signs if my view is not correct? What contra-indications should I be on the look-out for? What kind of movement, news, or information would indicate that I might be wrong?' Of course, do your analysis to the best of your ability - in order to give yourself the best chance of being right.BUT... Once you have your trade on, always be questioning: 'Am I really right?' Instead of wilfully insisting 'I am right!' even when the market is telling you otherwise. This is the kind of frame of mind, one of humility actually, that will allow you to see the light and cut
your losses early on. If you're not overly attached to your opinion, you'll give it up when the market tells you to. Be willing to say: 'You know what? I don't really know what's going on here. It's not making much sense to me.' And if that's the case - and be honest with yourself about it - then: 'When in doubt, stay out.' Or 'If in doubt, get out!'
This is not to say that you should panic and let go of your position every time the market has a whipsaw. Not at all! Know your limits. Know the level of risk you're comfortable with taking. Stay within those boundaries. You don't have to close the entire trade if you haven't reached your limit yet. BUT...if the jigsaw pieces are not making any sense, and you think what's going on might be a lot bigger than a whipsaw, then be willing to cut your losses early. So you can live to trade another day. Remember: in a fight between your opinion and the market... the market is usually going to win! The
market can remain illogical longer than you can often remain solvent! (Especially if you use a high degree of leverage).

3. Remain flexible

You never really KNOW which way the stock or a market will move. You will have your opinion of course... But you can't know for sure.

This is the essence of uncertainty. So you have to be ready for anything.
Flexibility allows for greater adaptation and response to changing circumstances, especially during times of rapid change such as major market volatility. Be willing to turn on a dime, if the situation calls for it, and perhaps abandon your long position and go short instead. Be willing to adapt to what is actually happening, instead of being attached to what you think should
be happening.

4. Focus on decisions not outcomes

People who display OUTCOME BIAS think they made a good decision when things turn out well, and a poor decision when things turn out badly. BUT...Isn't there such a thing as making a profit for the wrong reasons? I mean, gamblers do it all the
time. A gambler might get lucky. He might make a win occasionally. But unless he has a rigorous process to his decision-making, he's probably not going to end up being profitable in the long run. There are also times when you might do everything right in terms of your analysis and decision making process, and it still doesn't work out. Something random happens, it doesn't go your way, and you have to cut your losses. Just because it didn't work out, doesn't mean the process by which you formed your opinion and made your decision was necessarily faulty. That decision making process could still be profitable in the long run.

There are 2 errors in logic that make overcoming OUTCOME BIAS harder:

a) Recency Bias. This is the tendency to weigh the most recent experience more heavily in our decisions than less recent experience. For example, a bad recent trade can undermine our otherwise strong confidence in our decision-making process if we're not careful.

b) Belief in the Law of Small Numbers. This is the tendency to place too much significance on a relatively small number of events within a larger context. In other words, you start to second-guess your trading plan after only a couple of poor trades. The problem is that you have to place a reasonable amount of trades to be able to really test your trading plan. So if you want to gain confidence in your plan, you need to limit the size of your trades initially, so you can make more of them and repeat the process over and over.

5. Be Grateful for both donations and profits

Just because a trade does not turn out the way you expected it to, doesn't necessarily mean that taking the trade was a mistake. Even the best trading ideas or processes won't work every time. The very presence of uncertainty guarantees that we will be wrong at least some of the time. So be aware that losses are just part of the game. You can't avoid them. You can only minimise them.

Learn to view then as a learning experience, and as a necessary part of honing your trading skills. Remember that it's not about being perfect, or even striving for perfection. No.

The most important thing is actually discipline.

If you're a disciplined trader, you don't even necessarily have to be right more often than you're wrong. Yes, that's right. You can be WRONG more often than you are RIGHT and still be profitable!

As long as you have the discipline to cut your losses short, to lock in some profits along the way, and leave a portion to ride on successful trades (when they come) to let some of the profits run... if you can do all that, then it IS possible to be wrong more often than you are right and still trade profitably. Of course, it's easy to be grateful for your profits. But be grateful for your donations too: LEARN
from them. USE them. And, when it comes to your profits, beware of GREED. Greed will tell you not to take profits along the way - NO, NO, says greed: hold out for the motherload! The problem is, the market can turn on you any moment, and the profits you didn't lock in can be wiped out, and you can even end up in a loss situation. It's always a good idea to take some
profits along the way so that you are sure to get your initial investment back, as well as a decent profit.

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