1.
Do you make this huge trading mistake?
http://www.netpicks.com/do-you-make-this-huge-trading-mistake/

2.
It's not always easy to figure out
exactly how someone else interprets
trading knowledge and whether they
truly understand the implications of it.

3.
Sometimes it takes a chance
conversation in order to pick apart just
how differently your own
interpretation may be. Recently I was
lucky enough to have such a
conversation and a huge trading
mistake became apparent.

4.
The way risk is handled by Van Tharp,
as I'm sure many of you will already
know, is by expectancy. Expectancy is
basically your average trade in terms
of your initial risk.

5.
So if your initial risk on a trade is $500
and the trade goes on to make $1,000,
the trade is said to have made a 2R
profit. If initial risk is $300 and you
lose $450, you've lost 1.5R.

6.
The way I see this is that it's a very
good way to compare the quality of
trades where the specific $ amounts
don't always align particularly well and
it gives you a better idea of what you
should expect to make or lose on each
trade you take.

7.
In my opinion, this analysis is
particularly well-suited to people
trading across a broader range of
products such as a portfolio of stocks
and this is how my chance
conversation began.

8.
My friend and I were talking about his
stock trading and he was eager for me
to take a look at his portfolio so he
could show me what he'd been doing.

9.
As he ran through his different open
positions, of which there were around
50, I struggled to get an idea of how
good each trade really was - and that's
when I asked him about whether he
uses expectancy.

10.
He said that he didn't know about
expectancy and asked me to explain it.
After a basic explanation, I set about
pulling in his trade data to do a quick
demonstration of expectancy for him,
but as I started to break things down,
something concerned me greatly.

11.
"So what's your initial risk for this
trade?" I asked. "Well I don't really
have one." He replied. "Well where
would you be wrong?" I pushed, wide-
eyed.

12.
The conversation continued in this
manner for a while, with me trying to
get to the bottom of what he thought
of as risk. "So if you don't have a stop,
you'd let this stock go to zero?" I
asked. "Well yeah, but it's a great
stock!"

13.
Incredible. Not only did he not define
his risk, but what eventually became
apparent was that he felt that only
going for trades with "at least a 2:1
R:R" adequately covered it.

14.
Again, I'm wide-eyed at this point.
What R:R does do in combination with
win rate, is define whether or not an
opportunity is worth taking or not.

15.
It doesn't tell you the value of your
initial risk in isolation. It tells you the
ratio of what you make when a trade
works to what you lose when a trade
doesn't work.

16.
But it might be enough to figure out
what your initial risk is so long as you
identify the other side of the equation
- what your profit target will be.

17.
To quote a very famous and successful
trader: - "Losers average losers"
- Paul Tudor Jones.
This wisdom seems pretty obvious on
the face of it, but let's think in terms of
my friend and his stock portfolio
trades once again.

18.
There are two types of entry risk you
can take - one is information risk the
other is price risk. Many people
struggle to find the right balance even
if they understand the principles at
work.

19.
But there are also two types of trade
risk people take - one is account equity
risk and the other is market behavior
risk.

20.
Account equity risk is risk relative to
the capital in your account and it's all
about staying in the game long enough
to make your trading edge pay.

21.
Market behavior risk is the risk that a
market will change behavior and the
probability of price moving
significantly against your position.
Both must be accounted for. However,
like my friend, most people tend to
only focus on account equity risk.

22.
It turns out that my friend "improves
the average price" of his trades as the
market moves against him. He's
basically taking longer term views and
trading around his position (not simply
adding all the way down).

23.
So account equity risk is clearly
something he's trying to factor in. In
fact, I see nothing wrong with a skilled
trader doing this.

24.
UNLESS they do not take into account
that there's a point when the market
changes in behavior and demonstrates
that the trade is probably wrong. This
is market behavior risk.

25.
In reality, it's best defined by a
combination of a threshold technical
price level and a shift in behavior on a
breach of this price.
My friend accounted for neither.

26.
The true wisdom in what Jones was
saying is this: when a trade is a loser
(not just off side) you shouldn't still be
looking to take positions in the same
direction.

27.
Many traders look at a market in a way
that is totally skewed towards their
own interaction with it rather than
based on a market's own action. More
precisely, some traders trade in $ and
not in market price.

28.
True, the markets are a sum of their
participants' behavior. However, it's
highly unlikely that a market is going to
flip its current behavior just because
Joe Bloggs hits a 10 tick stop.

29.
But it might just change if it breaks a
key technical price level for example -
and it's at this point that it's probably
not wise to hold or add to your original
position.

30.
Excellence in trading comes in part
from understanding that it's critical to
marry the ideas of risk and create a
strategy that encompasses both
account equity risk and market
behavior risk. If you don't make it your
business to do this, you'll also make
this huge trading mistake.