The Dow Jones rises and falls 500 points a day. Gold climbs $60 in on session. Oil has $5 and $10 moves in a week. Corn trades to limit up on the market opening. Market volatility is climbing to an all-time high. Trading these markets offers plenty of reward, but the risks of losses are great if not managed properly. While opportunity for profits is greater with market volatility, the same holds for the risk of loss. Ensuring that proper risk management fundamentals are in place is more important than ever before in this chaotic environment.
John Maynard Keynes, a prominent economist, is quoted as saying that, “[m]arkets can remain irrational far longer than you or I can remain solvent”. Think this only applies to small traders? Look at Long Term Capital Management, Amaranth Advisors, Lehman Brothers, or any number of hedge funds that have blown up over the years. Numerous firms and traders have lost all of their capital based on poor risk management skills. There isn’t an individual or institution with unlimited access to capital. By preparing for the worst and hoping for the best, a trader can set proper risk management rules to maximize returns over the long term. As a trader, it’s not about how much money you make, it’s about how much money you keep. Does it really matter if you make $10,000.00 on one trade only to lose your entire account on the next trade? Getting stopped out of a losing trade is never fun and it’s painful. Often times a trader will be stopped out of a market only to see it turn around. Short term profits are temporary especially if they were obtained through poor trade management. In the long run, the market always seems to punish traders that don’t have a planned out strategy for accepting loses. A good trader will take this a step further and embrace his loses; he will study what occurred and work to improve on his technique.
Trading and War?
Sun Tzu states in The Art of War, “[e]very battle is won and lost before it is even fought”. This quote is thousands of years old and yet it still has relevance in today’s trading environment. Planning a trade takes preparation that allows for the known and unknown. By properly setting a trade up the trader can focus on the markets and not the noise surrounding them. Plan the trade, trade the plan. While this may be easier said than done, it is the basis for proper trade management. While a trader may be disappointed when the market moves against him, by having a stop properly placed he will not be devastated by the move.
Where is the benefit in winning a couple battles but losing the war? This is especially true when trading. Profiting from a couple trades and letting losses ride is the essence of winning the battle but losing the war. It’s always better to limit ones losses, preserve ones capital, and live to fight another day. One bad trade can wipe out an entire account. The market is unforgiving, and by not establishing loss limits the market will punish you eventually. All the work is done before the trade is even placed. Trading isn’t a sprint, it’s a marathon. Stringing together a good plan and generating good trade ideas while sticking to the discipline of accepting market losses is tough to do. Establishing positive results takes time, commitment, and discipline.
But how do I know that it’s a loser?
This is actually a question I sought to answer when I first started trading. For too long I was convinced that good traders knew exactly where to get out if the trade moved against them. I finally came to the realization that every trader just has an idea, and the best traders were able to move on after “puking” out of their losing trades. I realized that the best traders didn’t know the market direction every time, but what they did know was how to manage winning and losing trades properly.
How does a trader know where to place a stop loss in the market? Not only can this be challenging, it can also evoke some emotion. No one has a crystal ball and is right 100% of the time (just ask Warren Buffet, George Soros, or Bill Gross). In the end, the majority of traders have a couple of indicators and the confidence in the markets to place the trade. While putting a trade in these terms make it sound simple, the challenge lies in setting this up. Whether a trader decides to place a stop loss at key technical levels, fundamental news cycles, or a combination of both is up to the trader and the style that he chooses. Importantly, there are a couple rules:
- Take small losses and try for large winners
- Prepare yourself mentally for market activity that may not make sense
- Scale back position sizes in volatile markets
- Keep a positive attitude
- Be realistic about setting stop losses and profit targets
None of what has been written above is rocket science. It is basic common sense. Because trading can be so emotional, setting up strict rules and following them can make all the difference. While a trade won’t work out every time, getting out of a losing trade allows a trader the opportunity to fight another day. By setting up a stop loss and adhering to it, a trader takes out the difficult and emotional decision while the market is moving. Trading is hard enough. By properly managing risk a trader can focus his efforts on finding good trades rather than hoping and praying that he somehow luckily stumbles into a winning trade.
Basic Training for Futures Traders
This guide provides tips for successful commodity trading compiled from the advice of more than one thousand futures brokers. The top 50 of more than five thousand suggestions are included in this guide.