How to be a Trader: Risk Management & Emotions
New traders sometimes have visions of making a lot of money very quickly. The possibility is clearly there. The
reality is that they will probably lose all their trading money due to poor risk management. Ralph Vance did an
experiment with 40 PhD's in which they would gamble 100 times in a game where they would be guaranteed to
win 60% of the time. They started out with $1,000. If they had bet exactly $10 on each round they would have each
had $1,200 left at the end of the test.
If they had bet the mathematically optimal amount of 20% then they would
have had $7,490. However, only 2 had more than $1,000 at the end of the test. These were smart people who thought
that they could do it by using their instincts rather than by calculating the correct answer. Later I will show
you how to calculate the right amount to risk on each trade.
If you lose 20% of your account then you need to earn 25% profits to get your account back to where you were. If
you lose 25% then you need 33% in profits, if you lose 40% then you need 67% in profits, and if you lose 50% then
you need 100% in profits to get back to even money. With each loss your account is getting smaller and you are
using more leverage on each trade to maintain a constant trade size.
If you take too much risk, then you will lose all your invested money -even if you are smart and have a very
successful method of trading. To thrive in trading you need to be able to survive the inevitable setbacks.
B.F. Skinner authored an important work on behavior in the Journal of Experimental Psychology. Pigeons were fed
with a timer regardless of their behavior. The Pigeons generally identified the feeding time with the wrong cause.
One bird believed that turning counter-clockwise at least 2 or 3 times was the cause of the arrival of food. Another
repeatedly thrust its head into one of the upper corners of the cage. A third developed a 'tossing' response, as if
placing its head beneath an invisible bar and lifting it repeatedly. Two birds developed a pendulum
motion of the head and body. Many traders act the same way, developing trading rules that have nothing to do with
actual causes. These rules tend to destroy rather then improve their trading system and increase rather than
reduce risk. A good trading system should not be changed when you get a few losers in a row or have some bad weeks.
There are two questions that you ned to ask yourself in risk management: 1) Do I feel like this trade will make me
a big profit as a percent of my trading account size?, and 2) Does the level of risk feel a little scary? If you
can answer yes to either of the above questions then you have too much risk for your situation and experience level.
Never add to a losing position to try and save it. If you went in light and adding more later was part of your
original trading plan, then you can add to it but don't try to save a loser by adding to it.
The training of sports athletes is an excellent example to follow in learning to successfully trade. What would
you expect of an athlete that did not practice?
Some people have said that paper trading is worthless because nothing is at risk. If you were a college basketball
coach and one of your players said that to you would you agree? In practice you sharpen your key skills through
repetition until you internalize them in a way
that produces reliable performance. In that way, when the real game is on, and the tension is high, you can fall
back on your training and do what you reflexively know how to do.
Without practice you will not do things correctly, lose money, doubt your abilities, and be unable to remember
what it was that you did correctly or how you did it. It is a terrible time of self-doubt and you will need to
start all over again on the process of learning to trade. If you screw up bad enough then you may be unable to
trade due to the deeply impressed fear and pain of so many bad trades.
Perfect practice makes for good trading. Poor practice leads to lost money. Don't stop paper trading until your
practice sessions tell you that you are ready. Would you look forward to a basketball game if all your players
missed their shots in practice?
The best way to begin trading is with paper money. It is easy to keep your emotions out of it and to concentrate
on practicing your methodology. Then begin trading small positions where the losers, when they occur, are just a
minor nuisance. Scale up your size until you are trading the right size for your account.
The market will tease your emotions to do the wrong thing: sell at the bottom and buy at the top. You need to
re-train your emotions to respond correctly to the market. This will take some time. In the meantime you need to
resist the fear and greed that will lose you money.
Emotion is not all bad. Fear is bad. Greed is bad. pride is bad. Anger can be good if it prompts you to take
your painful lesson, learn from it, and aggressively put it to work. If your painful lesson makes you fearful of
more pain, then that is very bad.
The trader who has too much pride will stick to a trade long after he should have exited it because he refuses to
admit defeat. Sometimes it is a conviction that is the result of extensive research that keeps him in the trade.
For successful traders, discipline always trumps conviction. No matter how right you think you are, and you may
ultimately be proven right, you must always follow your risk management rules when your exit criteria is met
(never enter a trade without knowing your exit). Being wrong won't kill you but staying wrong will. Don't stay
long stocks that go down every day because you hope to sell it on a bounce.
Confirmation bias is a serious problem for people and can be a disaster for trading. Confirmation bias is when you
tend to favor information that agrees with you and discount information that disagrees with you. It makes you slow
to accept change when change is in the early stages.
In one experiment the subjects were sellers of some items. One set of sellers owned the items and another set
were selling it for someone else. Both sets of sellers set the sale price for the items. The sellers who owned
the items felt the items had higher value and demanded a higher price than those who did not own them. The items
were exactly the same but the personal ownership increased the perception of value. As a trader, we will tend
to stand by our own views more stubbornly than the views we have heard expressed by others. If we are bullish
then we will stick stubbornly to that view longer than if we heard bullish views expressed by another
trader. This bias has no basis in reality, just ownership. It is not wrong to have a view, just don't hold onto
it for the wrong reasons when change is at hand.
You should not be a cheerleader for a market or a stock. It is just a trade, not a marriage. In trading, you
need to love nothing and hate nothing.