Some risk questions answered

I received a nice email a couple of days ago from one of the traders in the mentoring programme. He asked a number of questions concerning risk and the associated psychology, which, as he said, "maybe an inspiration for a nice blog post!", so with his permission I've split his email down below and followed with my own comments and thoughts.

First of all I would say that this individual has previously traded/invested in the markets, however not with the benefit of using a complete, robust, system. He has been, and continues to be, successful in his other business endeavours, and now wants to participate more in the markets. I know in the past he had a big losing position in a commodity, which he referred to in his email, and this has made him extremely risk-averse, to the point where he is struggling to put on his trades.

The first thing he mentions is "This week I learned that reading about risk is easy. Putting the trades on in real life is much more difficult! To actually be in the now and know that even the first trade can go against you and cost you money is psychologically quite hard. Even if you know that in the long run you have the edge... It shows me even better why having a system is that important."

He goes on - "It's stupid but having an open position long in silver of x euro without a stop is more easy then placing the stop loss and know it will cut your trade... crazy if you think about it."

Finally, "For now I think I have to cut my position size down to an amount I'm comfortable with. The thing I ask myself is, even if the risk is just 2 percent. What do you do when the numbers get really big?... can you keep looking as it is just 2 percent?... what is your view on this?"

As I have mentioned on here in several posts, it is a lot easier to have the necessary discipline and emotional 'balance' if your risk is under control. If you find you are still fretting over each position, and are unable to second-guess and sabotage your trading by overriding your system rules, I would suggest cutting your position size in half, until you obtain the sense of 'emotional indifference' towards each position. If you do this and have still not reached that state, cut your position size in half again. If you want the big rewards, you have to accept the associated risk, without trading too aggressively and putting yourself in danger of risk of ruin.

(Incidentally, I have come across another example of this with another trader. He utilises an intraday system based on trends that has positive expectancy, yet is making losses. He places a stop on every position he takes, and faithfully takes and accepts all his losses. But he is losing money. Why? On his winning trades, he is afraid of losing the profits being generated. So, he ends up taking profits way too early (which potentially would be several times his initial risk), and ultimately turns a winning system into a losing one.)

His comments about being more comfortable when not using a stop are also interesting. All I would say on this is the old adage that 'your first loss is your best loss'. Cutting your losses before they get out of control will help emotionally, however you have to accept that a lot of profitable trading methods (including a trend following strategy) have quite a low overall win percentage, yet this cutting of losses helps create their inherent positive expectancy. Therefore, it is essential to exit a position when it goes against you.

In theory, providing there are no position size constraints, you should approach a trade the same whether your account size is £1,000, £100,000 or £1million. Your risk should be the same in percentage terms. The idea is to get the basic principles down pat as early as possible in your career. It is far easier to stick to good habits than to unlearn bad ones. Therefore, if you can avoid the temptation to trade too large when you have a small amount of equity, and stick to those parameters as you become more confident and profitable, then you have the foundations in place for long-term success. Using fixed fractional position sizing will allow you to grow your trading account while risking the same amount in percentage terms. Also bear in mind that if you do encounter a string of losses, or you decide to withdraw some funds from your trading account, by using the same method your position size in terms of money should be reduced, but will remain the same in percentage terms.

On a positive note, I would also say that his questions show a degree of confidence, in that he doesn't ask "if" the numbers get really big, but "when". This may strike you as being arrogant, however having spoken to the individual for several hours, and had plenty of additional correspondence with him over the last couple of months, I know that his large commodity loss has made him risk averse, and that he now appreciates how important risk control is to long-term success in the markets. Rest assured, as part of his mentoring I will keep monitoring this very closely! The system he is now using to determine entries and exits (trend following) is the last part of the jigsaw, after deciding he was suited best to this general style of trading, allied to implementing a robust risk management approach.

Finally, I would suggest watching the 'Trading and psychology' video I have posted, which may assist you in looking at your trading approach from a different angle.