November 14, 2007 • Reprints
Shared by Foretrader Futures Trading Team
RISK CONTROL TECHNIQUES
There are several ways you can manage risk. First, know your personal risk tolerance. You must have a good idea of the maximum exposure that you are willing to take. Likewise, to apply that self-knowledge, you’ll need to calculate the risk of a trade before you take it. Determine the maximum amount of money that could be lost on the trade and honestly ask yourself if you are willing to accept it. If so, consider the trade; if not, walk away.
One great characteristic of the financial markets is there is always another trade. In a few hours or days, there will be another chance to make a trade that better fits your particular risk parameters. Be patient and wait for it.
A day trader, of course, generally makes a lot of trades. Therefore, day traders must manage every trade carefully. That means always using a protective stop and knowing when a loser will be liquidated. It’s not a bad idea, for purposes of risk management, to live by the cardinal rule to never trade without a stop. Bottom line, when you assume a position, place a stop loss.
Before making the trade, identify the point at which the market will make clear that the trade is wrong. For example, if buying an S&P contract at 1472.00 and the charts suggest that support should step in at 1469.00; place a protective stop at 1468.50. The reason is simple: If that stop is hit, the market has demonstrated loud and clear that the original analysis was wrong. Take the small loss and gracefully go to the sidelines. Another opportunity will come along soon enough—and maybe immediately in the opposite direction of your original trade (see: “When to say quit,” below).
Not only do you want to know your risk tolerance, but you also want to know what to expect from your trading style. For example, if you do a lot of momentum trading, that is, you look for market opportunities when market momentum will move prices quickly up or down for a short distance, you should expect to be paid quickly. Intraday momentum trades might require profits in a few minutes if they are valid. If they aren’t showing any, check your indicators and reanalyze. If there’s no clear reason to continue the trade, exit and wait.
Do not over trade. The biggest weakness of most traders is a lack of patience. They sit in front of their computer screens waiting to trade. Because they have planned to trade, they do so. They are not discriminating enough, jumping in and out of the market continuously.
Remember, every time a trade is made, a risk is assumed. Therefore, one of the easiest ways to reduce risk is not to over trade. Have a workable and tested strategy. Know the market setup that supports that strategy and be patient. Chances are, if you are making more than five or six trades a day, then you are over trading. Take only those trades that look really good, those that meet all of the parameters of your strategy. Otherwise, the bad trades will deplete all of the money you made on your good trades.
To help end over trading, adopt this simple rule: Three strikes and you’re out. If you make three bad trades in a row, even if you manage the trades well and suffer only a small loss, close your trading platform and walk away. Something is wrong. You are off your game. Either the market is tricky and not following the rules, or some other problem exists. At any rate, do not trade in a market that is taking your money.
There’s some truth to the cliché that if you take care of the downside, the upside will take care of itself. Along those lines, always focus on preserving capital. While an all-or-nothing strategy might pay off big from time to time, it will not last in the long run. That is, if you make a trade and hold your positions until the maximum profit target is hit, you will do extremely well sometimes, but end up with nothing most times.
Instead, scale in and out of some contracts or positions at various profit levels. This approach is known as the 3Ts of Trading. In simple terms, it describes trading in multiples of three. When you enter a trade, know your profit targets and enter your orders to liquidate some positions at those targets.
A good first target would be only a few ticks from entry. Take, say, one-third or so of the position off the table. If the trade continues to work, exit another portion when the second profit target is reached. At this point, assume you have made enough money to cover the downside of the remaining positions. You are then free to either liquidate the last portion of the trade with the profits made, or you can place a protective stop at a breakeven point and let the balance ride (see “The 3Ts,” below).
Trading is not easy. It demands good analysis, good execution and good risk management. Those who succeed in the game are those who manage every trade and continuously respect risk.
BALANCING FEAR AND GREED
Psychology plays a huge role in trading. Many traders understand how to trade and could be highly profitable, but they continuously shoot themselves in the foot by being emotionally unbalanced. Regardless of your self-control, as a trader, there are two big emotions that you know all too well: fear and greed. These two forces impair analysis and keep traders from doing their best.
Greed leads to seeing money in every setup. Greedy traders trade too often and take far too many risks. Even when winning trades are made, these traders often end up losing money because they do not take reasonable profits. They want huge profits. Therefore, they keep holding positions until the market shifts and a winner becomes a loser.
The primal human emotion of greed is just one reason you should consider forcing yourself to take profits at various pre-planned levels. It keeps greed in check. It allows for a portion of the position to ride for maximum profits while taking smaller profits along the way to reduce risk and put money in the bank.
Fear has the opposite effect of greed. Traders make too few trades. They see the setup, they know it meets their criteria and is in line with their strategy, but they fear losing. Fear keeps them from making the trade and from making money.
Another aspect of fear is that it leads traders to exit winners too quickly. If one indicator goes against them, they bail. It is good to get out of losers quickly, but give yourself time to analyze what is happening. Risk management works both ways. A trader needs to get out when his risk limits are hit and needs to give each trade a chance to hit its profit target in the prescribed timeframe. A trader who is too fearful will never take risks and he will never make money. Winning traders put the odds on their side. They do their analysis, have a strategy and execute it as planned. They understand when the odds shift and are no longer in their favor and that is the time to exit the position.
Again, one of the best techniques for balancing fear and greed is the 3Ts approach. Trade in multiples of three and take profits at various profit levels. The first profit target will be just a few ticks from entry. The second profit target could be generally a point or so higher. Finally, the final portion of the trade is either liquidated with a
little more profit or it is left in the market to follow the daily trend and maximize profits.
The 3Ts approach concedes to fear and quickly reduces risk while pocketing some cash. But it also gives greed its due. Once you have exited the first two portions of the trade, the final portion is allowed to ride and take all it can out of the day’s market trend. This risk management technique allows you to maximize profits while also reducing risk. It helps create that delicate balance of fear and greed.
Join us and we will show you how you can use some simple risk management rules on your futures trading to generate and scale your account and be consistent.
Futures trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing one’s financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.
HYPOTHETICAL PERFORMANCE DISCLAIMER:
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES LIKE THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.