Managing Risks

Last night I spoke with a trader who had lost a lot of money. I realized very quickly that he was trading directionally with no hedge. Greed and fear had taken control. This is the worst-case scenario that can happen in trading; you lose money, you try to recover the loss, and you lose more again. You can't pry yourself loose from the computer screen. Going further, the whole process becomes addictive, much like gambling. This is how many traders lose everything and finally have to give up.

There are people who aspire to be full-time traders. Certainly, it can be a rewarding alternative, especially if you have some capital to trade. You can virtually work anywhere that has internet access; you have control of your time and have a steady income (that is if you avoid the above mistakes). It is especially great for me as I live along the Pacific West Coast. So my routine involves waking up at 5.30am, and at 6.30am PST the market opens. I spend some time in the market for an hour or two, watching for reactions to economic data, earnings releases, and trades put in by amateur traders before they head off to their day-jobs. In the middle of the morning I head off for a game of tennis or work out at the local gym. I am back in the market at about 10.30am PST--when Wall Street traders have just returned from lunch; this is when most of the action starts. At 1pm PST, the market closes and I can call it a day!

To become a full-time trader, first make sure you have a clear system that allows you to be consistent and disciplined over time. Initially, you should stay with a full-time job and only trade part-time, on a modest budget. Until you have become consistent and confident that trading can replace your full-time job, you should not resign and become a full-time trader. Before you can trade reliably on a full-time basis, there is invariably a learning curve that involves time, discipline, and dedication. This process ranges from 6 months--if you're particularly quick on the uptake--to even 1-2 years for many people. Before embarking full-time, make sure that you have started off with paper-trading, and then has traded with consistently good results for at least 6 months with a disciplined limit of real money. You should achieve a rate of 80% positive trades before considering trading as your chief or sole source of income. I would consider these to be absolute and minimum requirements.

While it is possible to be consistently profitable in trading, it is not easy. You need a clear system with an edge that fits your personality. By mastering trading, I mean that you need to have core competence that gives you competitive advantage over the majority of traders. Think of the whole exercise like starting up a new business. Draft out a realistic business plan. You do not jump into a pool without learning how to swim, drive a car without passing driving tests or practice a profession without appropriate training and certification. Trading is not simple. Only about 5% of traders consistently succeed.

One primary key to trading is risk control. Control the risk and the profit will take care of itself. Always remember to keep the hedge.

In many ways, trading is a probability game. Contrary to what is taught in business schools, the market is irrational. Effort must be focused on balancing risks and rewards to pursue your target profit. In my case, I use options to manage the risk. At the same time, do not allow any position in the account to get too large. If you need to understand the mechanics of position sizing, some of the best ideas on this can be found in Van Tharp's book.

Respect the market. In my > 10 years of trading, I had been humbled by the market many times. While tomes have been written on how the market is supposed to behave under certain conditions, in practice the market is capricious and is not obliged to behave in any set pattern. Many have learned in costly ways that they cannot pigeon-hole it; it is also almost god-like in its power to consume a person, and put his livelihood and well-being at its arbitrary mercy. Do not ever think you can outsmart the market. Always think of it as dealing with a powerful, live creature with a will of its own, and be ready any moment to admit you had been wrong, to reassess the situation and to change tack accordingly.

Stop-loss is an necessary evil. You have to keep your losses small. One of the commonest mistakes is to allow your losses to spiral to a dangerous amount. The advantage of 'options' is that once you've learnt to use it properly, you will not need to use stop-losses anymore.

Discipline is the key. Know your primary and secondary exit. Plan your trades, and trade your plan.

One of the first things I learned in trading is that “the trend is your friend”. Always trade with the trend. This is counter-intuitive, however. It took me quite a number of years to change the entrenched habit of trying to catch-the-bottom and sell-at-the-top.

Limit the maximum loss in your portfolio. A guideline is that if the portfolio drops below 10%, you should stop trading and re-examine your modus operandus. Never allow any individual position to lose more than 2% of your portfolio. Return to paper-trading for a while until you experience the positive zone of success in your trades, before embarking on real money again.

Protect your profit. A 'collar' is the most effective system for doing this. Once the market is uncertain, add the SC. Do not hesitate to add 'puts' if the trend is clearly down. Normally, I add the SC first. If the stock continues to break up, I will roll the SC up or sometimes just close the SC. If the stock breaks down, add a put. Read the post on how I use puts.

If there is a holy grail for trading, this is it: manage the risks of a portfolio through proper risk-control and management.

If the fundamental is intact, I may average down on shares when there are signals of bottom. A typical signal is when a stock has reached multiple-month or -year support with a bullish formation on candlesticks or MACD. Examine the fundamentals again to make sure it is intact. Only average down if the stock drops more than 20%. If you tightly manage your trades, even if the stock drops 20%, you normally lose only 5%. The SCs and puts will help to reduce your loss. Catching the bottom is a tricky thing. It can be like catching a falling knife. While averaging down, keep the hedge until the breakout is clear.

Finally, do not day-trade. My basis for entering a trade is the fundamentals. I use technicals to time the entry and exits. Options are used to hedge and actually eliminate the rampant emotions generated by day-traders and computerized trading. In this era of automatic trading algorithms generated by super computers, it is difficult to scalp winners against these machines. But with options, you actually capitalize on all the fears and emotions left in the wake of high-frequency trading, and this buys you time to give your trade an edge.