Trading Psychology and Risk Management
A burning question when you begin your trading career is “Why do most traders fail?”
Day trading requires you to make quick decisions and at the same time to be very disciplined. When you hear breaking news that an activist investor has just taken a stake in Amazon.com Inc., your initial reaction might be to load the boat. I can hear the logic that compels you. “Let's buy 5,000 shares in Amazon! Let’s put on a big order!” But you need to be able to make a quick decision on whether you should buy or sell or sell short that stock, and you need to make that call with discipline.
My trading strategies slowly improved with time, but the breakthrough came when I realized that the key to winning was controlling myself and practicing self-discipline. It is hard enough to know what the market will do, but if you don’t know what you will do, the game is lost. New trading strategies, tips from me or from this book, or even the most sophisticated software imaginable, will not help traders who cannot handle themselves.
You must ask yourself questions:
- Does this fit into my trading strategy?
- What strategy will this fit into?
- If this trade goes the wrong way, where is my stop?
- How much money am I risking in the trade, and what is the reward potential?
This is what many traders find difficult. All of these decisions, the very process of making sure these decisions fit into your risk tolerance and your strategy parameters, are a tough multitasking call. Not only is it multitasking, but it is multitasking while under stress.
I understand that stress. There have been times when I've been in the trade, had $15,000 in shares, and all I needed to do was sell. But as I was looking at my keyboard, I couldn’t even figure out which keys to punch. This sort of paralysis is not unusual when you’re overwhelmed. Whenever that happens, you need to realize that you have pushed yourself a little too far out of your comfort zone. It happens to every single one of us. Expect it to. Once you have some experience under your belt, it’s good to work on the edge of your comfort zone so you're always pushing your boundaries. However, if you find yourself too far outside of your comfort zone and outside of your risk tolerance, you can end up making some significant and costly mistakes.
I encourage you to foster a state of self-awareness within yourself. Dial in:
- Are you focused?
- Are you calm?
- Are you making good decisions?
Be in touch with the results of your decisions and constantly be reviewing your performance.
- Are you trading profitably?
- Have you had five winners in a row or have you had five losses in a row?
- If you are on a losing streak, will you be in touch with your own emotions and maintain your composure, or will you let your judgment?
I cannot overstate how critical that skill will be.
Consider skill and discipline to be your trading muscles. Muscles require exercise to grow and, once you’ve grown them, they need to be exercised or you will lose them. That's what I experience every day: continually exercising my ability to practice self-control and discipline.
Some of these skills, however, are comparable to learning to ride a bicycle. Once you’ve learned it, riding a bike is a skill that can’t be taken away. Once you’ve learned it, the skill of identifying a good stock chart isn’t going to go away. But remember, discipline is something you will need to constantly work at to be a successful trader. You’ve entered a profession in which you will always be learning. That’s great. In fact, it’s better than great - it’s stimulating. But it's important to remember that if you start to get over-confident and think you’ve outsmarted the market on trading wisdom, or that you don’t need to learn any more, you’ll often get a quick reminder from that market. You’ll lose money and you will see that the market is correcting you.
I will reiterate: being able to make quick decisions and being able to make and then follow your trading rules are critical for success in the market. As you continue through this book, you are going to read much about risk management. Everything that traders do comes back to risk management because ultimately it is the most important concept for a trader to understand. All day long, you are managing risk. Related to this is the ability to manage risk so that you will make good decisions - even in the heat of the moment.
That’s the next rule of day trading:
Rule 6: Your broker will buy and sell stocks for you. Your only job as a day trader is to manage risk. You cannot be a successful day trader without excellent risk management skills, even if you are the master of many effective strategies.
As mentioned before, traders are in the business of trading. You need to define your risk as a business person - the maximum amount of money you’ll risk on any single trade. Unfortunately, there is no standard dollar amount that I can suggest. As explained earlier, an acceptable risk depends on the size of your trading account as well as on your trading method, personality and risk tolerance. But remember the 2% rule explained above. It is worth repeating:
The absolute maximum traders may risk on any trade is 2% of their account equity. For example, if you have a $30,000 account, you may not risk more than $600 per trade, and if you have a $10,000 account, you may not risk more than $200. If your account is small, limit yourself to trading fewer shares. If you see an attractive trade, but a logical stop would have to be placed where more than 2% of your equity would be at risk, pass on that trade and look for another trade. You may risk less, but you may never risk more. You must avoid risking more than 2% on a trade.