Flexible expectations

Finding the trades

While there are many parts of trading business that are essential to trader’s success, the core area is undoubtedly finding and executing the trades. There are two parts of our every day trading process that are designed with that purpose in mind: Analysis System and Entry System.

Analysis System is designed to understand the current market conditions. It helps identifying what we can do on the market. It does not tell us when to trade, but it should certainly tell us when NOT to trade. To me, the essence of market analysis is to identify trading pairs where there is a higher chance of the price going in one direction over the other. When such trading pairs are found, the Entry System comes to action.

Entry System is designed to look for specific entry patterns in the direction identified by our market analysis. Main question that a good Entry System should ask is “Where do I put my Stop Loss order?” No matter what entry parameters we use, what targets we set, there is only one variable we have control over, and that is the amount of money we are willing to pay the market to find whether our trade is going to work or not (see the article in Issue 3). There is always a certain point in any market, beyond which it is not feasible to hold a losing trade. Thus, finding this stop point is the most important task of the Entry System. Without good Stop Loss, there should be no entry in the first place.

After identifying a good technical place for the Stop Loss, we will see whether the price is too far away from it, preventing us from having a good Risk/Reward ratio. When we see that Stop Loss can be placed in a good location, which is not too far away from the current price, we are ready to look for the entry itself.

At this point we already know:

  1. The market bias, or the path of least resistance in which we want to trade, that was identified by our Analysis System;
  2. A good Stop Loss price, beyond which it is not feasible to hold the losing position;
  3. We also decided that the distance to our Stop Loss leaves enough room on the other side (that is, profit side), so that our target can be placed with a good Risk/Reward ratio (ideally the potential reward should be at least 3 times the predefined risk).

All that remains at this point is to find the entry trigger, defined in our Entry System. For some it can be a certain indicator signal – I personally prefer to use Price Action patterns.

Executing the trades

After both the Analysis System and Entry System processes are finished, we should be able to take a trade right at that moment, since we know everything we need to do that. Unfortunately, often it is not the case, as we start to think and hesitate, trying to find the best trade of the day or making sure that it is “truly” the right signal. More often than not such hesitation leads to consulting the information that we do not use in our trading system, and therefore do not know how to use properly. The result is almost universally losses, frustration and subsequent psychological breakdown, leading to even more trading errors.

Even though our trading process should give crystal clear signals what to do or not do right this moment, at the same time we are always facing a certain amount of subjectivity on the market, as we can never predict the price precisely. We are building certain expectations where the price will go, and such expectations should never be made rigid.

Market expectations

It is very important not to have any attachment to our market expectations, as it is one of the main reasons leading to frustration and consequently psychological problems.

Think about it as a weather forecast. While modern technology increased the precision greatly, the weather can still be unpredictable, especially in some parts of the world. When you read the forecast, you build certain expectations for your day, possibly you are planning your weekend according to that forecast. Now, you may be planning a family lunch in the park on Sunday and your expectation, according to the weather forecast, is for a sunny day. After you made all the preparations on Sunday morning, it suddenly starts to rain, and does not look like it is going to stop.

What are your reactions to this situation? Are you going to be upset because you have to change your plans completely? Are you somewhat angry at the forecast stations, since they obviously made such a big mistake? Or are you going to quickly adjust your plans and spend a pleasant day with your family at home?

I am using this example because the way we treat such life situations will be the way we treat our market analysis. If we are not able to stay flexible in simple life situations and adjust the plans, we are not going to be able to stay flexible on the market, where the real money is at risk. Just like the attachment to our plans for the weekend leads to anger and frustration, so will our attachment to market analysis, and even more so.

When you expect the market to break the resistance and go higher, but it doesn’t, how do you feel? What if you already opened a position on the break and now watching the price go against you? Not only you are watching your loss growing, but more importantly, you are dealing with being wrong. The market went against your expectations, making you wrong. Or did it?

Being wrong

In modern life there are not many things that cause psychological pain for most people more than losing money and being wrong. You will find a lot of discussion in various resources about the necessity of accepting the risk and being ready to lose money (I prefer to think of it not as “losing” but as simple expenses of doing business or tuition fee if you are only starting the education). While acceptance of monetary risk is extremely important, another risk in our trading is being wrong, and I think it causes much more grief than the loss of money itself.

Think about it, most people build their whole lives around trying to be right. They argue, they try to prove, they believe to hold the truth that others need to know. How many people do you know that will continue the argument beyond any reason, when it is clear to everyone but themselves that they are wrong?

There is a vicious cycle that is created from attachment to our expectations:

  1. We learn about the market and find a method of analysis that we like;
  2. We apply it and build some rigid expectations about the future price movement;
  3. We act upon our expectations, placing money at risk;
  4. The market goes against our position “making” us lose money AND “making” us wrong;
  5. Fear and anger arise and we continue learning more about the market, with only one purpose in mind: to find a method where the market will not make us wrong. To prove to the market that we are right.

In this situation a trader is personifying the market, assigning certain qualities to it that allow the market to “go against” trader’s position and to “make him wrong”. However, in reality the market is a collective entity, comprised of millions of traders just like himself, and all it does is simply follows the rules to try and balance supply and demand.

The problem here is not the loss that we experienced – after all I am yet to meet a trader who will state that it is possible to trade without losses and with no risk. The problem is our expectations being too rigid while our trading regimen is too flexible.

The thinking goes like this:

“I expect the market to break this level and go higher, so it MUST do that. If it doesn’t do that, it is making me wrong and that is unacceptable to me. I must refine my trading method so that the market follows my expectations precisely, then I will show it!”

In other words, there is no way the trader is willing to change his expectations and review his analysis – after all he believes that the market MUST follow it. However, he is very willing to change his trading rules to adjust them in such a way that the market always follows his expectations.

Now compare it with the opposite attitude:

“My current premise was not in line with the money flow on the market and so my position got stopped out. By going in the opposite direction the market is providing me with new information that I can now use to review my bias and find new trading opportunities”

This thinking will allow the trader to build a better premise, because he has been exposed to additional information about the money flow on the market. Not only will he be able to learn from a possible mistake he’s made when defining his original premise, but also he will instantly see additional opportunities that the market is now making available to him.

One attitude says “This is unacceptable, I resent the price going against my position. I will make sure this never happens again”, while the other asks “What other trading opportunities are available to me now with this new information the market provided me with?” It is not difficult to see what is more helpful to the trader’s development. The first trader is full of ego, he is looking for someone to blame other than himself. The second trader is humble and accepts full responsibility for all his actions, which empowers him greatly.

In my opinion these two attitudes separate consistently winning traders from everyone else.

Summary

The psychology and trader’s mindset are closely related to his trading method, his profit expectations and ultimately to his consistency and success. If trading system allows to trade randomly, without rigid rules to enter and support a position, it will lead to losses and frustration. If your risk management allows to overtrade, not controlling the amount of money you can allocate for trading every day or each month, sooner or later it will backfire and cause irreversible losses, when one day can lose more than was made in the past half a year.

It is up to us to create a trading system with rigid rules, and to have the discipline to follow these rules. At the same time we have to develop a high level of mental flexibility, letting go of our expectations easily and adjusting to the new information the market is providing us with.

We can also see a relation between our trading term and the amount of difficulty we will have to control our business properly. When trading intraday, the market is pouring new information on us with such a high speed that it is beyond most traders to absorb it and account for this information on the fly. It is much easier to overtrade when you watch the chart in real time and see one minute candle forming after another. Undoubtedly, there are traders who reached high degrees of success in short term trading, but I would argue that overall success rate is much higher for the followers of a longer term approach.

However, no matter how much we discuss the trading psychology and proper mindset, it is very unlikely to rewire our brain just by thinking about it. A great amount of everyday practice is necessary in order to change many beliefs we’ve been living with for years. In the next issue we will setup a practice routine that is designed to ingrain the new beliefs about the market, risk management, our expectations and trading execution. By following such routine we will be able to change how our brain operates, remove the hesitation and anxiety out of equation and develop the mindset that is most likely to lead to a consistent success in trading.

Trading Accountability

Handling complexity

In his book “The Checklist Manifesto” Atul Gawande shows how very costly mistakes are avoided using simple paper checklists. He provides a very detailed account that we can learn a lot from.

The truth about modern life is that it became way too complex for most people to handle by keeping information in their heads. We cannot account for all the variables of the modern life. The doctor is not able to concentrate on everything anymore, the modern operations are way too complex. The pilot cannot control a modern airplane and keep all the details in his head, no matter how good he is at remembering things.

It is not by accident that all modern pilots are required to go through simple paper checklists. In the midst of all technical complexity of their cockpit, they have to take a simple paper checklist and go through it for virtually every single procedure they are doing. Similarly, a nurse can stop the surgeon before the operation and remind him that some simple check has been missed in a checklist that nowadays is a requirement in most modern hospitals. No matter how good the surgeon is, a simple piece of paper has proven times and times again to be better in avoiding crucial mistakes that cost lives.

In trading we can exercise the power of checklists like never before.

I was always a big proponent of simplicity of trading. I was always defending the position that a mid to long term trader can simply spend an hour a day checking the entry conditions, taking the trades and then calling it a day. To be fair, the analysis and placement of the orders really does take a couple hours but somehow I was never able to make it to consistency by doing just that. The answer is that I was never a trader and I certainly never managed a trading business. I was an analyst at best, a market hobbyist at worst.

Analyzing the market and then trading your plan are two very important parts that we already discussed before but they are only that – two parts of the whole, only two elements of your trading business. A surgeon who learned the anatomy of human body and how to use the scalpel and stopped right there will never be allowed to work in any hospital. He must understand the management, the paper work, preparing reports, planning the operation, have critical thinking to decide the best course of action.

Whether you make money in trading or lose depends on how you manage your trading business as a whole. That consists of your monthly accounting and review, weekly goals and limits as well as review, daily plan, analysis schedule, trade management, recording all your trades in a diary, gathering statistics for different types of entries, timeframes, pairs, etc. As you can see, the problem is not in the complexity of a particular trading method but in the amount of work that has to be conducted regularly to maintain trading as a successful business.

More importantly, besides regular daily life of a trader, there is another crucial part to it. Just like in any other business you must advance in order to stay on top. You cannot start an endeavor in any competitive segment of the market and hope to make it, if your knowledge base always stays the same, if you never learn and never improve. Trading, being extremely competitive, is where one must advance every single day.

Do you know the problem areas of your trading business? If you lose money, do you have a clear picture HOW exactly you lose it? Is it a certain mistake you repeat times and times again or a trading timeframe you can never get right? If you are making money with a certain degree of consistency how do you know it will stay the same tomorrow? What can you improve to stay on top of the market even better?

There are stages to development of a trader: you are first oblivious to these questions, then you ask them and then you try to answer. After you find some answers all you’ve really done is built a theory on how to improve a certain aspect of your trading. The next step is to put that theory to practice and see how well it works in real life.

The real simplicity of trading

When you created a system of accountability for yourself in form of trading diary, log and various process checklists, you have made a big step towards consistently. If we have no clear idea what to do in our business we can still work hard and stay busy every single day, spending countless hours, but in the end we can only reach consistency by being extremely lucky.

Here is why creating an accountability system is so powerful: it lets you know clearly if you are doing your job or not. In the end of the day you look back and see your diary entries, trading log, start of the day checklist, daily summary checklist and you know what you accomplished today and where you fell short of ideal.

When you have a trading system with clear rules and accountability system with clear rules, all that is left is to follow them every single day. At this point, the trading is still not easy because of the amount of work you have to do, but now it became simple – in a sense that you clearly know every step that needs to be done every trading day. When you are not satisfied with the results of your trading, you can always look back and analyze what can be improved. You can make a couple changes and then see how well they work after another couple weeks.

One of the main reason why the traders are so rarely reaching consistent success, in my opinion, is that there is little to none consistency in their approach. Some are inconsistent in their life habits: waking up at the same time to start trading day, analyzing the market at the same time, following healthy sleep regimen to stay alert and concentrated during work hours, eating properly to have enough energy, etc. Others are inconsistent in their trading approach: jumping from one trading system to another, constantly modifying their trading rules, not following the rules in the first place. Finally, I think most traders are not consistent in doing proper accounting of their business: market analysis is not systematically recorded, the trades are not logged and analyzed for mistakes, studying the market may be done sporadically and so on.

Having the discipline in all these areas is extremely important. As I keep stressing, being a trader is, first of all, being a businessman. A business owner is completely accountable for everything he is doing. The problem, however, is that he is accountable only to himself which makes it easy to avoid in the short term, destroying all chances for success in the long term.

Accountability system

There are 2 elements of accountability system that I think most important to trading success: morning checklist and evening checklist. These simple lists will guide you throughout the day, always making sure that you are on the right track.

Next, I suggest setting up 2 separate journals: Market Diary and Trading Log. I use Market Diary to record any interesting trading pairs, trade setups, trading ideas, etc. The Trading Log is used to record each and every trade that was taken. First of all I write all data about the trade: trading pair, direction, size, time, price, etc. Then I describe the trade setup – the signal that I used to open this trade. Finally, the most important part of the trading log, is to record my psychological state upon entering the trade. I write if there was any hesitation to pull the trigger, what was my state of mind, any distracting thoughts, etc. I repeat all the same steps when the trade is closed. A screenshot of the chart is also added upon entering the trade and later showing how the trade has been closed.

Now that the basic setup is done, all is left is to make sure that the work is done properly every day:

  1. All market analysis and trade setups are recorded in Market Diary
  2. Trading Log keeps every single trade that was opened and closed along with psychological analysis

Next, we make sure that we advance in our understanding of the markets:

  1. We spend at least 10 minutes a day reading a market related book;
  2. Along with current market analysis, at least one historical setup is reviewed to ensure that we learn something new about the market.

We hold ourselves accountable to do this work consistently by following the checklists. In the morning we check:

  1. Wake up at the same hour, before everyone else, to create a productive and distraction-free start of the day;
  2. Re-read Market diary from the previous day to get into the right mindset first thing in the morning;
  3. Review any trades in Trading Log that were taken yesterday and document any trades that were closed since yesterday.

In my opinion getting into the habit of waking up at the same time every single day (including the weekend) is one of the most powerful things we can do to our success. By waking up before everyone else around, you create a distraction free environment that can become the most productive time of the day. When the day has been started with positive action advancing you in life, it will be much easier to keep going in the same fashion for the whole day.

Next, we follow through our market analysis checklist, which is created specifically for our trading system. The main goal is to look for all trading setups of our system on all trading instruments that we watch and record all this information in Market Diary as a clear trading plan.

Now we are ready to go through the Take Action checklist. This list is designed to help us pull the trigger and open the actual trades. Here we check:

  1. What trade setups we have available and clearly described in our Market Diary – if there is no plan put on paper, we don’t trade;
  2. Check our risk allocation for today (following the guidelines discussed in the previous issue);
  3. Place the trades according to plan, making sure that we use only allocated risk;
  4. Document the trade entry in the Trading Log.

Depending on trading timeframe and trading system, it is possible that market analysis will need to be done more than once daily. In this example we use swing trading on Daily charts, allowing us to analyze and place trades only once a day, thanks to the fact that there is only one new Daily candle available.

In the end of the work hours it is very beneficial to use Daily Summary checklist:

  1. Check once again that all analyzed signals were taken and everything was documented;
  2. Do all necessary paperwork preparations for the next trading day;
  3. Clean the workspace, ensuring that the next day can be started without any distractions.

Of course, we looked only through a very basic example here. It simply provides an idea how one can organize his working day. Every trader should prepare detailed checklists for his particular method of market analysis.

Trading is definitely not easy, but it can and should be made simpler. The checklists help to cut through all the guesswork and instead manage the work each day with absolute clarity, knowing that nothing important is missed.

Setting up the limits

Unrealistic expectations

As I mentioned many times before, it is my opinion that your expectations about the market is one of the most important aspects in defining you as a consistently profitable trader. Market is unlike any day job in that you do not have a clear certainty in your expectations, like the amount of your paycheck, possible promotions, vacations, health plan, etc. When you trade for living all these variables have to be defined by you. Alas, not all of them can be clearly defined at all.

In the previous article we discussed how you can build your expectations about the amount of work you have to do, how often you have to analyze the market, for how long you are going to hold the trades, etc. Today I would like to concentrate on another very important aspect, that of your profit expectations.

I think that many traders start with completely unrealistic expectations, which leads to a lot of frustration and emotional pain as they cannot get these fulfilled. When you see ads on TV with a truck driver owning his private island, implying that he bought it from the profits made in the market in his free time, it is not difficult to understand why so many traders are greatly misled.

Profit generation

First of all, let’s take a look at how the profit is generated on the market. At first sight it seems an obvious question – the profit is generated by the trades we close and open. I would like to argue that it is not as simple as that.

In my opinion it is much more beneficial to view the direct outcome of the trades as the return ratio between the risk in these trades and the reward they return in terms of price movement that was taken. In other words, if the trade returned 100 pips and we risked to be stopped out at -50, this trade generated the return ratio of 2 (100/50). I find such definition much more helpful because it emphasizes that our profit is always tied to our risk, to the potential loss we can have on that trade.

I keep emphasizing that on the market the goal number #1 is survival, i.e. account preservation. We have to play good defense before we can start applying offense.

With most investing even if you put all your money in just one company you are risking blowing up the whole account only if the company’s stock ends up trading completely worthless and there is no one who will take it from you even for free. When you distribute your money between 10 different companies in different sectors you chances of blowing up 100% of your original stake are getting pretty low. With options, futures or on Forex everyone is so used to huge leverage that they cannot even imagine trading without it.

When you trade on Forex, you normally get anywhere from 1:50 to 1:100 leverage. The leverage basically means that you can invest 50 or 100 times more money than you own. However, when you invest 100 times more than you own, the account will be wiped out with only 1% move against you instead of 100% when you trade with no leverage. At the same time you can double your money 100 times faster when the price goes in your favor.

Let’s take a look at a reasonably conservative example. Let’s say that we want to limit our potential losses to no more than 10% a month calculated from the initial capital at the start of the month. Given 20 trading days a month, we will have 0.5% risk available each day. To make sure we don’t lose all the money we already made, let’s say that we never open more than 0.5% worth of new positions on any given day.

Let’s say we lose 10% a month for the whole year and we started with $10 000. What is the size of our capital by the end of the year? No, we are not in debt of $2000 because we lost 120%. Our capital is still ~$2541. Because each month we recalculated our risks, when we lost the first 10% ($1000), the next month we only had $9000*10% = $900 available to risk. Essentially, it is not possible to blow up the whole account when using even such a simple money management technique.

However, let’s also consider how long it will take us to rebuild the account back to $10 000, giving the same trading rules and starting after 12 months of losses, i.e. at $2500. After 12 months stably making 10% and compounding our profits at the end of each month we will be at $7846. It will take another two and a half months before we arrived back to $10 000.

Even though it took us longer to rebuild back the losses, let’s consider it in a different way. During the first year, while we were consistently losing 10% a month, we ended up with approximately 75% loss – at $2500. The next year, when we started making 10% with the same consistency and reinvesting our money back at the end of the month, we arrived to ~$7850 after 12 month – more than 200% increase over the initial $2500 we had left.

Compound interest

In order to restore our $2500 account back in short amount of time, we used compound interest – any profits that we were making, were left in the account and we continued trading with them. The power of compound interest is well known, however in order to exercise it we need enough confidence in the system. It is OK if we just made 10%, invested it back into the market and the next month lost 10% – we are just 1% less than we were 2 months back. But what about a possibility of losing 20% or 30% the next month? Heck, without proper risk management, losing 50% or 80% the next month is just as easy!

Ultimately, the appeal of a trading method should be judged not as the extreme returns it promises the next month but as the consistency of these returns over the next 10 years and more.

Of course, the issue for starting traders is often a lack of capital. When you start with $1000, 10% a month does not seem to be that big of a deal at all. I would argue that the real issue for starting traders is lack of patience, followed closely by the lack of confidence in their trading method.

Here is another example: how much do you think the initial $1000 deposit will grow in 10 years using the basic 10% a month scheme we looked at, reinvesting the profits each month? The result will be an astonishing $92,709,068.82. Improve your edge by as little as 1% additional profit a month and you end up with $274,635,993.25 by the end of the same period.

So, the main question is not whether you find a way to make 20% a month instead of 10%. The main question is whether you are going to stick to your system and reinvestment plan after 5 years, when your $1000 has already become a respectable $304,481.64. After you increased your account 300 times starting with $1000, are you going to trust your system to do the same in the next 5 years, now starting with $300K?

There are two important points that were mentioned:

  • The most important parameter of a trading system is its stability in long term performance
  • The profitability is only relevant compared to the drawdown the system can experience

First of all, we need to realize that right now we are only discussing controlled drawdown – the amount of loss we will accept willingly when the market goes against us. Our ability to control that drawdown is also dependent on the market – we need a valid price in area of our stop loss in order to get out of the market. In situations of major crashes such control is not always achievable, as you are unable to exit the market at a desired price. Different risk control measures need to be used there, to be discussed in separate article.

Limiting monthly risk

Assuming normal market conditions when we can exit with our loss at a predefined price, let’s discuss how we increase the appeal of our trading method.

Any profit outcome is only relevant relative to the amount of risk we exposed ourselves on the market. Let’s differentiate between the loss we experienced and the risk we were exposed to. It is possible to finish the month in 10% profit with the highest draw down being 2%. That amount of draw down was our loss that we experienced in the course of making our 10%. However, it is not the risk we were exposed to. To me, the definition of the risk starts with the amount of money we could have possibly lost if all our trades would have closed in a loss – the worst case scenario, very rare, but possible. However, I would complete that definition by adding that the risk exposure is not only limited to the trades we actually took during the month but any trades we might have taken as well. Let me explain what I mean by that.

First, the drawdown that we experienced is simply the amount of money we were down during the month. We opened 20 trades and at some point a series of trades resulted in 2% consecutive draw down. It might have happened at any time during the month. We still closed the month with 10% profit.

The actual risk exposure during that month is defined as the amount of loss we would experience if all the trades would have failed. If we risked 1% a trade, our actual risk exposure was 20% – that is the amount we would have lost with same 20 trades failing one after another. Unless, of course, our system is limiting the potential of our risk exposure.

The potential risk exposure is defined as the amount of money we would have lost on all the trades we could have entered, limited by our system rules. What I mean by this is that our trading system may strictly forbid any trading past a certain loss threshold. In our example throughout this article the potential risk exposure was strictly limited at 10%, because all the trading stops, if such a loss is reached in any given month. Of course, it is still up to the trader to honor such limitation, but that is a matter of trading psychology and not system Money and Risk Management.

Limiting daily risk

Coming back to the example, there is another extremely important limitation we established in our trading system. Not only we limited the potential risk exposure at 10% a month, but we also limited the risk exposure during any given day at 0,5%, ensuring that we arrive at 10% loss only by consistently losing day in, day out. Let’s see why it is so important.

Imagine another system where potential monthly loss is also limited at 10%, but there is no such daily limit. The trader is using the system successfully, confident that he is well protected against any market surprises and will survive through the bad times.

Let’s say on a certain day the trades sees a great opportunity to buy USD against other currencies. He then opens EURUSD sell trade and GBPUSD trade with 0.5% risk each – very conservative approach. The next day he sees that the market retraced against him and stopped out the trades, but fails to go any further, therefore confirming his bias that the USD bears are very weak. This time even better entries are available on USDCAD, USDCHF and USDJPY, along with the same EURUSD and GBPUSD. Excited, he buys first 3 pairs and sells EUR and GBP again.

Alas, the market is still trading sideways and his stops are narrowly hit. Frustrated, our trader starts looking for explanation with further analysis and sees that the market was just reaching a round number. Now that the level of support was hit, he is even more confident in the reversal, because his original signals stays the same – buy USD against other currencies. Looking at his loss of 3.5% with quiet disgust, he decides to make the money back fast, with a near profit target and puts 1% risk into the same 7 pairs. Predictable as markets are in such situation, his stops are taken before the price finally moves in his direction. The trader, however, already hit his 10% limit and even exceeded it by 0.5%.

Did I mentioned that all of this happened in the first 5 days of the month?

There are many problems with his risk control:

  1. Because he didn’t limit his daily loss limit, he was susceptible to trading on emotions as well as overtrading.
  2. When the market was not presenting easy opportunities he managed to reach his loss limit in just a couple days and could not do anything for the reminder of the month.
  3. Because there is no daily limit, the trading can become very poorly diversified – the trader risked 0.5% in a couple USD pairs, knowing that when they move they usually do so together in the same direction.
  4. The trader is extremely frustrated with his performance and now the question is whether he will be able to honor his monthly limit or not – in his current mental state, when he already made a series of bad mistakes, he is risking to break other rules as well.

Now we can compare it to our original method, where the risk is not only limited to 10% a month but also to 0.5% a day.

  1. When the market is difficult to trade the trader will have to choose the best trading opportunities or spread his 0.5% risk in a couple trades. In other words, such limit ensures diversification, since when the signal is presenting itself in multiple related pairs at the same time, the chances are that the trades in these pairs will close in a loss or a profit together.
  2. If the trader has bad attitude today and is susceptible to making errors, he will be forced to stay out of market very quickly, losing no more than 0.5%. By the next day he has enough time to cool down and trade with proper attitude.
  3. Even the worst market conditions do not last very long and by giving himself freedom to lose money every single day and still be able to continue trading the next day, the trader is maximizing his opportunities.
  4. Because each day presents a new trading opportunity, the trader is truly distributing the signals provided by his edge in a wide array of market situations, ensuring that no single event can affect his bottom line greatly.
  5. The trader is better protected against force-major situations, since his risk exposure on the market is always limited. Even if the market trades through his stop loss, the damage will not be as devastating.

Summary

Besides protecting the account from being wiped up by a couple erroneous errors, such trading limitations are even more important psychologically.

When this risk management system is setup, the trader can work with more confidenc. The system allows him to know clearly what will happen not only if this trade loses, but also if every trade will lose until the end of the month. The trader can concentrate on finding his edges and acting on them. Each day he knows his limits, and he also knows that no matter what happens, he can continue trading for the whole month, looking at new opportunities each day, without the fear of hitting his loss limit.

In later issues we will be discussing different variations of managing the risk of trading. We will also look at profit expectations that we can realistically have when such risk limits are used.