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Saturday, May 28, 2011

Resist the Lure of High Risk – Part 2

“The weaknesses of a trader can bring her/him down, if she/he doesn’t correct them as soon as they reveal themselves.” – Dr. Mircea Dologa

“The market will place us in a position where we can find out what we're made of so that we can choose to correct our weaknesses (and also to see our good traits and try to strengthen them).” – Joe Ross

Hello:

My heart goes to all traders who’ve suffered big losses and/or margin calls. I believe it was not your intention to enter the market to purposely ruin your accounts, but you were either misguided or weren’t adequately educated about safety measures in trading.

The scars of margin calls are everywhere.

Awareness of the importance of risk management has been heightened in recent years. But has greater awareness reduced the number of incidents of margin calls? No, that hasn’t been the case. Greed among traders is prevalent. It’s clear that many traders are willing to ruin their accounts rather than change. Many traders prefer to go thru harrowing experiences before they can accept this. If the future were accurately predictable, the majority of traders wouldn’t be losing, and this is the reason why I often recommend very small position sizing methods in my trading strategies, but they’re contrary to what many traders out there would like to do.

Sadly many traders suffer huge losses due to high risk, and they go on saying that trading the financial markets online is a ruse. For example, some blame the markets for the losses they suffer, all of which are their own doing. Novices are easily deceived by vendors who talk about nice profit and neglect or fail to exemplify risk control. If a software vendor or an analyst tells you that you can make 30%-100% per month with a strategy, did you know that you’d also be exposed to 30%-100% drawdown per month? Can you handle this amount of loss? Even 40% loss is too much for most professionals to handle – not to mention novice traders. It’s the same story with every analyst or vendor: If you follow their dangerous position sizing recommendations in your trading and get it wrong, you’d be the one to lose your money, not the analyst or vendor.

Marko Graenitz, in one of his cover stories, reveals that the worst bankruptcies in history did not just happen ‘by accident,’ but were primarily caused by the excessive use of leverage. There are parallels here to many private traders who may have had a good strategy, but ultimately entered too large positions and then ruined their account in a losing streak. It’s somewhat reassuring and sobering at the same time that even a billion-dollar hedge fund controlled by Nobel laureates has imploded because of this fundamental mistake. Studies show that it’s often harder to recover heavy losses sustained on trading portfolios. If the losses are small, eventual recovery would be easier. But if the losses are huge, eventual recovery would be very much harder.

Many novices became bitter as a result of what they suffered in the markets. Wise traders, on the other hand, viewed what they suffered as a psychologically strengthening experience. If you had a bad experience in the market, you needed to feel as though you were being trained for glorious days ahead. As for me, I learned the value of risk management from what I passed thru in the past. I made sure I used my lessons as a catalyst for better trading performances and never regretted it. I saw how trading portfolios could survive provided we stop emphasizing huge profits. You must always be cautious and constantly aware of the dangers of targeting high returns in a short period of time. It doesn’t matter whether one is managing a billion dollars or a thousand dollars; both amounts can experience huge drawdowns or be kept safe. It doesn’t matter whether you’re the most popular analyst in the world; everybody is subject to the uncertainties of the future events. Now, if I ever feel I need bigger returns, I reflect on my past experiences. I’ve often wondered if I would’ve been a good trader if I hadn’t passed thru a trying experience. I was convinced that the market is the best teacher for foolish traders.

Do honest-hearted traders find it difficult to adjust to the kind of trading mindset required for lasting success? One of the traders I personally mentor reports: “At first, I found it difficult. Many times I felt like giving up. But I’m glad I didn’t, for I came to appreciate and love the right mindset and effective risk management in trading. Being aware of the need to watch our wallet made us focus on the noblest trading target, which is safety, and not to get distracted by greed. I and my colleagues thought less and less about huge profits and more and more about capital preservation. Indeed, the survival we began to enjoy was unsurpassed. In terms of profits, we mightn’t even make up to 10% per annum (but sometimes we make between 40% - 60% per annum), but we were completely immune from huge drawdowns. We saw risk management in action despite the uncertainties of the markets – not just in connection with capital preservation but in protecting our nerves. Now we can face the future with confidence. When you don’t go after huge profits, that’s when you truly rely on safe position sizing and witness a permanent safety of your capital.”

Are you willing to lose your money before you appreciate its existence? Don’t forget that the first goal of every sane trader should be capital preservation. There’s always another opportunity, but only if you’re still in possession of your capital. If you wait until you receive a margin call before you take risk management seriously, you may find that you end up struggling with emotion of self-pity instead of dealing with the challenge successfully. Tell yourself that its more important for you not to go broke than to get rich quickly. Back your words with a position sizing method that can help you meet this objective.

I implore you, think about the techniques that successful funds managers may have used in keeping their funds permanently safe. Decide which of their risk management strategies you’d like to imitate when trading. Also decide which, if any, bad attitudes and trading methods you want to avoid repeating. Discuss your conclusion with an experienced trading risk manager. A novice trader can succeed more quickly if he takes safety measures very serious instead of thinking about getting a magical entry system which supposedly bring colossal profits.

NB: Please watch out for my coming articles with these titles: ‘Carrying Out Stealth Raids in Weak and Strong Markets,’ ‘Worst-case Scenarios’, ‘Effective Swing Trading in Forex’, ‘Advanced Gap Trading’, ‘3 Recent Gap Trades,’ ‘Trading for a Livelihood, ‘If I Were a Trading Neophyte…,’ ‘Developing the Right Attitude towards Losses (Part 2),’ ‘The True Holy Grail,’ ‘Monthly Trading Report,’ etc.

I end this article with quotes from Dr. Van K. Tharp:

1. “Do you remember your last big trading loss and how painful it was? Did it leave you shaking your head, clenching your jaw, feeling tight in your gut, or just staring at the screen in shock?”

2. “In terms of your equity, how big was that last big loss? Was it more than 1% of your equity? If it was, beware! You may be risking your entire trading account by not understanding the concept of position sizing strategies!”

3. “When applied to your trading system, your position sizing strategy—not the indicator, entry, or even your trading system—determines your profits and losses… If you risk more than 1% of your equity per position, you take on a higher risk of burning through your equity. Stay safe to live long enough in the markets so you can learn and improve.”

Your questions and opinions are highly welcome.

Thank you.

With best regards,

Azeez Mustapha

Forex Signals Strategist, Funds Manager &Coach

Senior Analyst

FX Instructor, LLC

Email: amustapha@fxinstructor.com

Yahoo! Messenger ID: saazalmu

Are you facing any challenges in trading? You might want to explore the secrets of markets wizards and duplicate their success. Get the secrets from my past articles at:

www.fxinstructor.com/blog/author/amustapha

www.fxinstructor.com/blog

Get my Forex trading signals at: http://www.fxinstructor.com/en/analytics/ituglobal

And my past articles are also available at: www.ituglobalforex.blogspot.com

NB: There is risk of loss in trading, but it is possible to be a successful trader.

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