BarroMetrics Views: Risk Management
What is risk management? For me it’s a set of tools that balance maximization of profitability with minimization of risk of ruin. It’s made up of two categories:
- Trade Management: the strategics and tactics to manage an initial exit (when we first place a trade) and the strategics and tactics to manage our position once a trade starts to move in our favour.
- Money Management: the strategies and tactics to answer four questions:
- How much to risk of this trade?
- How large a position size for this trade?
- The maximum portfolio risk at any one time?
- When to decrease and when to increase our trading capital i.e. at what point of the loss/profit cycle? For example: the simplest method is to increase or decrease after each trade.
But behind the strategies and tactics, a trader needs a certain mindset leading to certain habits and routines; this is what I’d like to talk about today.
When we first start to trade, we may get unlucky:
- we either get stopped out repeatedly only to have the market move in our favour and/or
- hold to losing trades and be rewarded with eventual profits
- taking positions too large for the capital and be rewarded with profits
As a result, we decide that no exit strategies are the way to go. Eventually of course, the market catches up with us: we learn that we need to cut our losses or we’ll blow our account; if we fail to learn this lesson, we eventually have to stop trading.
If we learn to cut our losses, our main tool, at least in the beginning, is the stop-loss order. Some of us never move beyond this tool. Others learn that preparation and defining the circumstances we will exit a position and under what circumstances we will remain takes precedence over the ‘stop-loss’ order.
This is easier said than done. As behavioural psychologists have observed, humans have a status quo bias. This means that once we are in a trade, we tend to look for reasons to remain in the trade. Add to this bias, the fear that if we exit a trade, it may go our way and you have powerful reasons why early exit is difficult.
But if you think about it, there is no reason why an ‘early exit’ (i.e. exit before the stop-loss order is elected) should not form part of our exit strategies. If we know why we take a trade and understand the assumptions behind it, then once the assumptions are invalidated – ‘if correct then the market will generally not behave this way’- we should exit.
In my case, I found keeping a journal an invaluable aid to train me to accept early exit. By keeping track of what did happen after an early exit, I proved to myself that my profitability increased. Yes my loss rate went up but the decrease in ‘average dollar loss’ more than made up for the higher loss rate.
So now, I prepare for a trade by defining what I expect to occur if my analysis is correct and what has to occur for me to consider early exit.