Day Trading: Learning to Manage Risk
Many novice day traders charge into the market full of exuberance and excitement about the potential profits they are about to realize. And some do. But the vast majority of new day traders are met with bitter disappointment and disillusionment. There's a reason for this; they only considered the winning trades they planned on initiating. It never occurred to them that all their trades may not go in the intended direction. It was a shock to them, at first, because the books they read show them all the good setups and a systematic method of trading. Somehow, it just didn't work out.
The story above is not an uncommon one, to say the least.
Learning to trade is as much about learning to manage winning trades as it is about learning to manage losing trades. Of course, managing winning trades is a lot more fun and a lot more gratifying. But sometimes you need to learn to manage trades that fall on the losing side of the equation. This part of trading is not a particularly enjoyable pastime, but it is every bit as essential as learning to manage winning trades.
Managing losing trades begins long before you make a trade. A good trader is constantly evaluating the risk involved in every trade. He or she uses a number of techniques to gauge the potential profit and loss and every trade. Personally, I rely upon the Average True Range as an excellent barometer of what I can expect in a potential trade. There are several other methods that traders employ to measure risk. Whatever method you use, use it consistently and across-the-board.
Once I have decided upon the level of risk I am willing to take I set my stops to reflect that risk. I have one hard and fast rule in the e-mini trading; I never move my stops downward to accommodate a losing trade. No matter how well I think the trade made pan out in the long run, I never chase good money after losing money. There are even those traders who add contracts to a losing trade and hopes of making a larger profit when the trade church around. I never add contracts to a losing trade. It just doesn't make sense to lower your stops or add contracts when you are already losing. After all, all you have is a hunch that the trade will turn around; there is no guarantee that the trade will reverse and head in the right direction. The truth is, the trader wants to trade to turn round and headed in the right direction. There is a gulf between knowing what a trade will do and wanting a trade to move in a certain direction. Don't get these two feelings mixed together for they are incongruent and do not reflect reality.
A wise trader never risks more of his futures trading account balance than necessary, and in my trading I try to stick to risking 5 to 8% per trade. No more. If you find yourself risking upwards of 20% of your account balance in a given trade you have far exceeded your limits and stand a good chance of eventually busting your account. Proper money management is essential to understand for any trader, and the first rule of money management is to not overextend yourself. I might add as a general observation that most traders tend to over extend themselves on a regular basis.
Finally, the most important aspect of controlling and managing risk in your trading is to take only high probability trades, and conversely, avoid low probability trades at all costs. I was just reading about a well-known trader who became very popular fading peaks and troughs for big gains. It was a very popular system in the early 2000's, but peaks and troughs are difficult to call and ultimately it led to his demise as a trader. High probability trades almost always occur with the trend, and most successful traders are committed to trading with the trend. This is not always easy as many very attractive setups pop up against the trend. This is a time when you have to ignore your indicators and oscillators and use good sense. All trends go through short or medium periods of retracement and typically resume in the direction of the trend. This can be a tough lesson to learn. Any trade against the trend is usually going to be a low probability trade and should be avoided. There are some notable exceptions to this rule, but by and large avoiding trading against the trend is sound advice.
In summary, we have talked about learning to limit your risk when trading. It's important not to move your stops downward or upward to accommodate a losing trade, nor is it wise to add contracts to a losing trade. Finally, we have discussed trading against the trend and focusing on high probability trades and avoiding low probability trades. Using these simple techniques you can take a sizable chunk of risk out of your trading, and that's the goal of all traders.
Questions and Answers
This article is the second in a series of three articles providing some tips on building successful trading models and systems.
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