Month: April 2015

Accepting the Risk, Part 1 – Stop Loss

Posted on by Anatoliy Schneider

…most traders erroneously assume that because they are engaged in the inherently risky activity of putting on and taking off trades, they are also accepting that risk. I will repeat that this assumption couldn’t be further from the truth.

Accepting the risk means accepting the consequences of your trades without emotional discomfort or fear. This means that you must learn how to think about trading and your relationship with the markets in such a way that the possibility of being wrong, losing, missing out, or leaving money on the table doesn’t cause your mental defense mechanisms to kick in and take you out of the opportunity flow.

— Mark Douglas “Trading in the Zone”

Risk and reward are closely related as we cannot have one without the other. I wrote my opinion many times before that a trade should not be judged as amount of pips or dollars that it makes. It should only be judged as the ratio between what was at risk and what was gained (could have been gained). A trade that made 100 pips but had 1000 pips SL has extremely poor 0.1 RR ratio and it is relatively easy to make such a trade and reach profit with it, just by sheer luck. A trade that made $1000 but had no SL has 0.0 RR since the was no risk limit, and we have to assume that the whole account was put at risk.

In terms of profit it does not matter whether we win 10 trades out of 10 with 0.1 RR or just 1 trade with 1 RR. If we risked $100 in each trade, in the end we’ve made $100 in each case. However, it matters a lot in terms of risk – in the first case we risked 10 times $100 to make $100 in the end, while in the second we risked $100 just once and made the same $100.

 It is interesting that most beginning traders prefer to take a smaller profit, while setting a bigger stop loss (actually, most beginners prefer not to set any stop at all, being sure that the market will go in their direction at least a tiny little bit). I think there is some interesting psychology that we can analyze here.

First of all, there is always a balance on the market. If your trading system uses 1:5 RR and you are able to win consistently more than 80% of your trades, it can still work just fine – especially if that is what your find to be psychologically comfortable. The problem here is actually going with the market flow correctly more than 80% of the time – easier said than done.

On the other hand if you take 3 times the profit compared to your risk you only need to be “right” 1 time out of 3 in order to consistently increase your balance.

Let’s think about it from a different point of view. Imagine that you trade manually and you put 100 pips stop loss trying to make 20 pips. What kind of trading opportunites are you looking for? What is the market setup where you say “The market gives signs that it will go 20 pips in my direction, but it can first retrace 100 pips against me”? Imagine the trade goes against you by 90 pips. What should the market conditions be at that moment that you still keep your trade with confidence – now you want the market to move 110 pips in your direction, having only 10 pips breathing space on the other side.

It really seems to me that trading in this way is a very dangerous psychological trap. It’s like we want our trades to be perfect, we really hate when the market goes against our positions and forces us to take a loss. But we learned that trading without loss protection is a financial suicide, so we calm ourselves by setting a huge stop loss while trying to take a tiny profit – after all, we are protecting our account, right? It really comes down to truly accepting the risk of our trading.

Accepting the risk of losing money

When a trader puts on a trade with a stop loss, he immediately assumes that he is accepting the risk that comes with that trade and that he is in control over his trading. However, we are not benefiting in any way from the risk “acceptance” that comes from the overwhelming fear of losing money.

A trader can put a stop loss, but still hope or even assume that the market will never reach it. He likes to put a bigger SL not because he is ready to take a bigger risk in his trading but because he is afraid to take any loss at all. He hopes that the bigger SL will never be hit. If there is any fear in placing the trade it means that the risk for that trade was never truly accepted.

When seeing your trade being closed in a loss causes you any emotional discomfort it is natural that you will do anything to avoid taking the loss in the first place. The smaller your stop is, the more often it will be hit. It seems that most traders prefer to increase the distance to their stop so that they do not have to experience the emotional pain that comes with losing money as often. Accordingly, bigger stop loss will possibly lead to more emotional pain when it is hit, but there is another element that I find even more important – the pain of being wrong.

Accepting the risk of being wrong

When the trade is stopped out an average trader not only feels the pain of losing money. He also perceives that the market is making him wrong, and for many traders the pain of being wrong is even stronger than that of a financial loss. I would say that even though the pain of losing money can be similar in one big loss or many small losses, the pain of being wrong on any given trade is about the same.

From this perspective we can see that for someone trading without proper mindset (someone experiencing any psychological discomfort at all about his trades) it makes sense to avoid the losses at all costs. He will much rather take $10 profit 10 times in a row, increasing his confidence (and often his ego) and then have 1 loss that takes all $100 away, than experience the pain from losing $10 and being wrong 5 times in a row and then making $100 on the trade that is opened with the market flow. In reality, such trader is very unlikely to last through 5 losses in a row and still continue following his system to get to that 6th trade that makes up for all his losses and more.

The risk of being wrong is rarely acknowledged, which makes it much trickier to work with. Unless a trader specifically studies trading psychology, he is rarely aware that he is actually afraid to take a trade because it might not work out.

How is it possible not to accept the risk?

In other words, how is it possible to participate in an activity (trading) that is risky by its very nature and not to accept the risk? Mark Douglas provides a very good explanation to the underlying psychology in his book:

The typical trader won’t predefine the risk of getting into a trade because he doesn’t believe it’s necessary. The only way he could believe “it isn’t necessary” is if he believes he knows what’s going to happen next. The reason he believes he knows what’s going to happen next is because he won’t get into a trade until he is convinced that he’s right. At the point where he’s convinced the trade will be a winner, it’s no longer necessary to define the risk (because if he’s right, there is no risk). Typical traders go through the exercise of convincing themselves that they’re right before they get into a trade, because the alternative (being wrong) is simply unacceptable.

Such thinking is leading to many problems in our trading. Instead of looking at the market as the source of trading opportunities he can act on, the trader thinks of it as the enemy he needs to fight. He is trying to learn everything he can about the market so that he can build such a trading system that will not lose any trades. The only way such trader can be psychologically comfortable with his trading is if he can win all his trades, since any single loss causes a lot of psychological pain that makes him start questioning his trading system.

You can imagine how difficult and frustrating such trading will be.

On the other hand, it is simply a matter of adjusting one’s beliefs and expectations about the market in order to solve this problem once and for all. A good trader does not simply say that it is possible to lose money on the market, he expects to lose money on any single trade he makes. He never knows what trades are going to be winners and which ones will pay the market for the opportunity to trade. A good trader sees such loses as the cost of doing business, similar to a restaurant owner who has to buy food before he can serve it to his customers for profit.

Practicing flawless execution

Posted on by Anatoliy Schneider

In the previous issue we discussed how our Analysis and Entry processes help us to find trading opportunities on the market. However, even when the trade is clearly identified many traders will still hesitate to take it.

Convincing yourself to take the trade

After the trades are clearly identified during the analysis phase, we still have to act on them. These are not trades yet, these are only signals.

It is a big trading problem if we have to convince ourselves to take the trades. In reality we should jump at an opportunity to execute the signal and move towards success. The fact that we are hesitating can mean only that we are not confident enough at what we are doing.

So how do you become more confident at it? By acting on each and every signal, time after time, and seeing progressively better results as you refine your rules and your system. In order to act on each signal, we need a confidence of a different kind – the confidence that we operate from a safe environment where nothing is threatening us and we have nothing to fear.

Easier said than done, but nothing we can’t achieve with help of proper money and risk management.

Risk Management

We will follow a simple MM strategy, as discussed in issue 6.

The very first goal we must become 100% comfortable with, is the fact that we have to pay for our education on the market. You might have taken classes, seminars or self-studied many books, but that’s only part of the price you have to pay – this is the price for the theoretical knowledge of the market. The next phase is to pay for your education by practicing all this theory.

You have to define the amount of money you are absolutely comfortable paying the market each month for your education. It can be anything, but it must be real money.

It does not matter if you can spend $1000 or $10 000 a month practicing trading if you are not psychologically comfortable leaving this money on the market. You have to go down until the amount bears no emotional attachment whatsoever. Let’s say it is a very conservative $100.

Now that you know your monthly tuition fee, you have to make sure that you trade, you practice with it, and you don’t lose it all the next day. Remember, you are setting your monthly limit and you will have to stick to it. The next step, therefore, is to divide that amount by 20, making sure you have something to risk each and every trading day of the month.

In our example it will amount only to $5 a day. Fortunately, there are brokers that will allow you to open so-called cent accounts, where your $100 will be shown as 10 000 cents, and you can risk $5 as if it would be $500, but in reality you are risking just 500 cents. Once again, the amount is not important right now, because we are not trying to make money, but become confident executing the real trades.

It is very important that you are absolutely comfortable with paying the market for your education, so this planning phase is crucial. It is just as important to learn paying with real money. Reduce the risk until you can confidently say that you are happy to pay the market every single day for the opportunity to learn from it. After all, there is no better teacher for our trading than the market itself, and it is the only teacher that allows you to set the daily education fee as low as you wish. Make it $1 a day if you have to, but commit to paying that price without any emotional discomfort.

Now that the risks have been defined and truly accepted, we are ready to enter the practice phase.

Practice

The goal of our practice is very simple: every single day we try to find just one single entry opportunity with our trading system and act on it, paying the market the daily fee we predefined in the previous step. At this point we must have an attitude that will make gladly accept every single opportunity as soon as it is confirmed. We do not think about money anymore, we know our tuition fee for the month.

Of course, there are a couple disciplinary rules we must follow:

  1. The trading opportunity must be defined objectively by the rigid rules of our trading system. It means that any other person should see the same entry if we put the trading rules in front of him.
  2. We are trading only under our risk limit for the day and after a trade is placed that fills that risk allowance completely, no more trades can be opened. Whether we decide to take one trade a day with full risk or divide it between two trades is up to us.
  3. The trading must be documented

The last point is very important and it is worth going into it in more detail. As we discussed in Issue 7, trading organization is just as important to our success as trading system or proper psychology. I call it Trading Accountability, because we must make ourselves accountable (responsible) for all our actions. For the purposes of this exercise let’s define 3 accountability rules we will follow:

  1. Before placing the trade, we make a picture of the chart and annotate it, explaining why this is a good trade opportunity. The picture is placed into our “Analysis Diary”
  2. Right after taking the trade, we write all details into our “Trading Log”: entry price, time, stop and profit target, risk for this trade, expected return ratio, etc. We also write down our psychological state of mind about this trade: do we feel good about it, was there any hesitation before taking the trade, etc.
  3. When the trade is closed we update our “Trading Log” with relevant information and write down a short analysis of the trade and how we feel about it now.

In the end of each week it is crucial to analyze trading results so far. Now we can see how the market developed after our entry and we can analyze our mistakes with a benefit of hindsight. It is the most important phase of this practice.

When this exercise is done for the first time, chances are that performance will not be outstanding. Many traders will think that it is simply a matter of trading rules that we developed so far for this exercise – if the rules are not good enough to show us good entries, then we will not see profitable results. However, after actually doing the exercise, we may see many trades where the rules were not followed.

We need to take each trade and compare it with our original analysis and entry system description:

  1. Did we follow all the rules in our analysis system, meaning that this trading pair had a bias in the direction we traded?
  2. Did we follow the rules of our entry system, clearly seeing a signal before we took the entry?
  3. Did we respect money and risk management?

Question 3 is by far the most important. It is understandable if we miss some sign of changing or weak bias in real time in our analysis system that is obvious to us with hindsight. It will also happen many times in the beginning that the entry is far from ideal, because of the many factors we have to account for. But our Risk Management rules are always simple and straightforward.

We know precisely what position size we must open, we know that there must be a stop loss set immediately with our entry and we know our risk limit for the day. We can only break these rules willingly, talking ourselves into not putting a stop loss order, because we “need to give the market space to breathe” or taking additional trades today, after reaching our limit because “the market is showing a signal that cannot lose”. Such lack of discipline and awareness over our thinking will lead to the greatest losses on the market.

If we find ourselves breaking Risk Management rules during our first series of trades, it is not the end of the world, we still did not waste the time doing the exercise. We have found that there is a serious issue in our psychology that we need to work on and that is a great advancement towards success. After all, most traders are losing money on the market (sometimes losing it all because of such judgment errors) completely unaware of the crucial mindset issues that they have.