The Way You Think

The way you think is the most important aspect of trading. There’s an old axiom which is still true, ‘Cut your losses and let your profits run’, which most traders know, but many find difficult to apply in practice. It is natural not to want to prove yourself wrong, and in a sense that’s what you’re doing when your trade doesn’t work out and you have to close out the position for a loss.

The truth about trading is that the market will do what it wants, and you are just trying to shorten the odds of picking winning trades by studying technical analysis. No one can predict just which way it will go, and therefore you have not necessarily failed if half your trades go the wrong way. You obviously hope for better than that, but with the best system in the world you will have a share of losers. You only fail if you allow those trades to decimate your account.

Successful traders focus on minimizing their losses. This is one of the secrets of winning at trading. If you do not cut your losses early by closing the trade when it reaches your stop loss level, you are making it much more difficult for yourself. Just imagine how difficult it will be to close it if and when it drops further– and you may be sure that it will drop further in a lot of cases. Hope is not a successful trading strategy, and the many traders who hope that the price will turn around and come back up to prove them right after all are doomed.

All this assumes no previous history or emotional baggage, but things can get even more difficult if you have had a succession of losses or wins. If you have had several losses, even if you are able to resist the temptation to trade for higher stakes in order to ‘make up’ the deficit if you win, you will also be tempted to close out your winning trades quickly rather than letting them run as you should. When you close for a win you will feel much better about yourself, and it’s hard to resist that temptation.

On the other hand, if you have had several wins you may be tempted to believe that you are better at trading than you really are, and take unnecessary risks. The fact is that the market has no memory of whether you “deserve” a win this time or not, so every trade you enter must be taken from a neutral position. And if the market did know, it wouldn’t care about you anyway!

If you want to gamble, Las Vegas may be a better place for you than the financial markets. Steady and consistent trading is the hallmark of those who make a living from the financial markets. It takes practice and willpower to develop the mental strength to trade correctly, but there is no other way to trade if you want to stay in it for the long haul.

Position Sizing

The other day after reviewing trades with one of my new trainees, we were stumped by the fact that she had taken every trade I had, with the exception of 2, yet I was up over a thousand pounds for the day, and she was up only £200. How? The 2 trades of mine that she missed only resulted in a net gain for me of £125, so that wasn’t the reason. After kicking it around for a few minutes I had the answer: Position Sizing.

Position Sizing tells a trader how much stock to buy. Correctly sizing your positions is one of the most important areas of trading as it affects both diversification and money management.

Factors that determine the size of your position include –

  1. the ratio of risk to reward for the trade
  2. risk tolerance of the trader
  3. trading account size
  4. current market exposure
  5. free equity

I’ve already mentioned position sizing, so I’ll just run through the process that you have to go through to determine how much money you should commit to a single position. You need to take into account the amount you want to risk losing on a trade, and I’d suggest you settle on the guideline of 2% of your trading account. Using your account value at the time, you can then calculate your risk amount.

Van Tharp talks about position sizing extensively in his book Trade Your Way to Financial Freedom as well as his many seminars. In fact, he believes that true success as a trader is found by trading a system that has a positive expectancy and the use of position sizing (varying your bet size). In day trading, you could argue that it is really not position sizing as Van Tharp describes it, but actually a way of taking the “temperature” of the market. Is the market allowing my trading system to get half-points or am I battling for 1/8ths and 1/16ths? Depending on your answer, you put more or less of your capital to work on each trade.

The difficult part for newer traders is recognizing when the market is set up for you to trade larger or smaller, typically your level of experience is the deciding factor. Case in point, one of my trading systems is a combination of mechanical and discretionary set-ups and when I speak about it I only talk about the mechanical aspect. The system is not terribly complex. As a result, most new traders trade every single set-up they see, and usually with poor results. That is why most trading systems fail miserably when people try to implement them. It is difficult to implement a mechanical trading system that has the ability to factor human judgement based on years of trading experience.

Also when it comes to position sizing, two percent may sound very small, but in actual fact it is not and is based on the experience of many traders over the years. Some professional traders will even work with smaller amounts, but then they can probably afford to as their accounts are usually large. Two percent represents a compromise which gives you a very good chance that you will not run out of money or have your account decimated even if you have a run of losses, yet still allows you to make a discernible profit. It is not a magic number, but you need to know what you’re doing before you stray far away.

The other reason that 2% works is that this is the amount that you allow yourself to face losing on each trade. It does not mean that that you only stake 2% on each trade, far from it, as it depends whether your whole stake is at risk for the trade you are making. But you must always look on the worst case outcome, and this will depend what financial security you are betting on, as well as what price you think the chart could go to.

Looking again at the security you are considering trading, you need to determine how far it can go in an adverse direction before you exit for a loss. This may be just below a previous support level, for example, or based on volatility. After making sure that your risk/return is worthwhile, all you have to do is divide your risk amount by the amount you’re prepared to let the price go against you before you cut your losses, and this will give you the maximum number of shares you should trade so that a losing position would not cost more than 2% of your account.

Depending how tight your stop loss is to your entry level, this may still be too large a position. You need to check it against the other guideline of not putting more than 10% of your account is any one position to avoid undue exposure, and purchase the smaller number of shares.

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