Trading Psychology

To the uninitiated, trading can seem like an easy way to make money. It’s tempting to think that all you have to do is buy something, wait for it to go up in price and then sell it at a profit.

 
 

 

Preserving your mental capital

But of course the reality is quite different, particularly when employing leverage and trading on margin. While profits can accrue rapidly, so can losses. Of course, nobody wants to lose money, whether through trading or anything else. Yet taking losses are an inevitable part of a trader’s life, particularly for short-term or day traders. This is an aspect of trading we are not only bound to experience, but something we have to endure and hopefully even learn from. The most important thing is to ensure that any trading losses are manageable – from both a financial and mental perspective.

Every trade is in essence a test of one’s theory concerning how a particular market may behave in the future. We may have undertaken thorough fundamental and technical analysis which has, to our minds, helped to support our hypothesis that a particular financial instrument will move in a certain direction over a period of time. Yet despite all our best endeavours the underlying market may not behave in the way we predicted. This could be a fault in our analysis, or it could be that unexpected events take over. Quite often, traders can be correct in their analysis but too quick to pull the trigger on the trade. This is particularly frustrating and it can also be extremely costly. There is nothing more mentally debilitating for a trader than to correctly predict a big move in a market but lose money in the short term by getting in too early. If they don’t have the discipline to cut their losses they won’t have the funds left to capitalise on the situation when it turns back in their favour. This is why all traders must pay particular attention to money and risk management – to preserve their financial, and mental, capital.

 

Money management

In the first instance this means disciplined money management. There’s really nothing particularly complicated about this as all it means is dividing up your risk capital into small parcels so you never risk too much on a single trade. If one trade doesn’t work out the way you hoped then you’ll still have funds left to trade again. Bear in mind: the strict definition of risk capital when dealing with leveraged trades is money you can afford to lose.

So the big issue is deciding how to divide this up. Some investors say you should never risk more than 1% of your risk capital on a single trade. Others say 3%, while 5% or even 10% may work for other people. It depends on a number of factors, such as how much risk capital you have in the first place, and whether you take positions over the short, medium or long-term. Typically, day traders trade more frequently than other traders. Consequently, they should be risking a smaller percentage of their risk capital per trade than medium or longer-term traders.

 

Other considerations

But there are other considerations to juggle as well. For instance, let’s assume you have trading funds of £5,000. Risking 1% on each trade will allow you to trade 100 times, but for a maximum loss of £50 on each occasion (this “maximum loss” is different to the margin requirement which is the amount of money you need to hold in your account in order to open and hold the position). This is where money management becomes intertwined with risk management. Risk management means planning your trade in advance and making sure you have a sensible stop-loss in place. Now it may be that attractive trading opportunities present themselves frequently, but taking your technical analysis into account you would have to risk more than £50 to include a prudent stop-loss. If this tells you that there’s a possibility of the market moving against you to test a significant chart level beyond your stop-loss, then it’s not worth placing the trade. You may get away with it, but the odds are probably against you.

The same is true even if you decide to risk £500 on a trade. This would give you far greater flexibility through your choice of trade size and where you place your stop. But risking 10% per trade with trading capital of £5,000 will give you just 10 trading opportunities, which is not something a novice trader should undertake.

 

Reduce your risk

It’s impossible to take the risk out of trading as that’s what it’s all about. So the most important thing for anyone to do is to reduce this risk to an acceptable level. This will vary from trader to trader. But do everything you can to make sure you’re comfortable with the risk you’re running on a particular trade BEFORE you open a position. This will help you to preserve your risk capital and assist in maintaining a healthy psychological outlook when you trade.

 

Risk Management

It doesn’t matter whether you’re spread betting or trading CFDs; whether you concentrate on FX, individual equities, commodities, stock indices or trade a bit of everything. When you trade on margin and employ leverage then it’s vitally important to spend time and effort incorporating money and risk management into your trading plan.

Everyone will have their own attitude and tolerance towards risk. But the bottom line is that leveraged trading exposes you to the possibility of losing more than your original deposit. This can be offset to a great extent by careful money and risk management, particularly if utilising guaranteed stops which protect you against even the most violent and unexpected market movements. But in this blog I want to look at some aspects of stop selection and how it relates to money management.

Let’s assume that you are fortunate enough to have £5,000-worth of risk capital - that is, £5,000 that you could afford to lose should the worst happen and none of your trades prove profitable. Now, the rules on money management tell you that you should divide this up into a number of tranches so that you’re not risking too much on each individual trade. In this instance “risk” is defined as the difference between the opening level and stop level of the trade, multiplied by the bet/trade size. Some traders say you should risk no more than 1 or 2% of your risk capital on each trade. With £5,000 this would suggest 100 trades risking £50 each time, or 50 trades risking £100. Of course, a less risk-averse trader could decide to divide up his or her capital into 20 tranches of £250. So what we’re saying in this example is that the difference between your opening level and stop level, multiplied by your bet/trade size should mean risking no more than £50, £100 or £250.

Now for any given amount of risk capital, the more you risk per trade means fewer overall trades. However, risking a larger amount per trade has the advantage of providing a greater number of potential trading opportunities. Risking a maximum of £250 on each trade means you would be able to take positions in markets which are typically volatile. Obviously, each trade will carry more risk than a position with a £100 or £50 limit on it, but it also means that you can place your stop further away (all trade/bet sizes being equal) which will give your trade more time to breathe and come to fruition.

Here’s a spread betting example:

In the chart below we can see a low-high move in the EURUSD with a Fibonacci Retracement on it. A trading opportunity presents itself after the pair retraces 76% of its initial move and you decide to buy. Your buying level is going to be somewhere above 1.0520 or so, and for the purposes of this example we’ll say it’s 1.0535. Now, you decide to place your stop a touch underneath the old low of 1.0495 - let’s say 1.0480. Consequently, and assuming the pair doesn’t gap below your stop, your potential loss is 55 points. If you were to do a minimum spread bet of £1 per point then your potential risk is £55. Consequently, if your money management rules say that your maximum risk per trade is £50 then you mustn’t place the bet. Obviously, you could if you’re prepared to risk either £100 or £250. In fact, you could buy up to £4 per point with the latter.

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Now it is important not to confuse your “risk per trade” and Spread Co’s margin requirement per trade. You must always hold sufficient funds in your account to cover the margin requirement on your open positions, together with any variation margin required. So, if the market has moved against you, but not far enough to trigger your stop, you may find that the combination of the initial margin requirement together with the variation margin requirement means you would need to hold funds in your account over and above the £50, £100 or £250 earmarked for a specific trade. Of course, this isn’t a situation which would arise if you were employing guaranteed stops.

 

Conclusion

Money and risk management are vitally important factors in the trading process. Getting this right will help you feel comfortable with your financial exposure to the markets. This in turn will go a long way to take emotion out of your trading so you can concentrate on the markets themselves.

 
 
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