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HOW TO MINIMIZE TRADING RISKMay 2010 Online Trading Academy
How to Minimize Trading Risk Tampa, Florida – (813) 933 4350 firstname.lastname@example.orgHow to Minimize Trading RiskTrading is tricky. You do it to make money. But if you focus on how much you’re making, you endup losing. That’s the way trading works. Unfortunately, most people are unaware of this. Imaginethat your brother-in-law is selling you on a hot business deal. What’s the first question you ask? Ifyou’re like most people, you ask, “How much can I make?” Because most people don’t understandthe importance of focusing on the downside. While it may seem like you’re betting against yourselfbefore you even begin, your first question should be, “How much can I lose?”If you focus on your downside, you end up making more. How is this possible? Successful traders(investors of all kinds, for that matter) spend time and energy preventing big losses. They’re notnaïve; they know they’ll have losing transactions. But they also know that if they keep those losersvery small relative to the potential gain from their winners, they will end up ahead. Here’s a simple,illustrative example: Let’s say you’re trading a strategy that loses half the time. One day you’re up,the next you’re down, back and forth like a coin toss. It doesn’t take an advanced degree in math toknow that this could be an extremely profitable strategy providing your winners are a bit larger thanyour losers. Win $2, lose $1. Do that over and over and see how happy you are!Simple math notwithstanding, the first step in minimizing your trading risk is not mathematical at all!It’s psychological. You must accept that you will have plenty of losing transactions withoutbecoming emotional. You will lose money, but you will also keep your cool. You must prepare yourego for a bruising… on a regular basis!So why would anyone want to endure losing, and losing often? Because a smart investor knowsthat over time, he will be a winner. Casinos work in much the same way. The house “edge” over allits players combined is small, maybe a few percent. But that few percent is more than enough topay off the occasional Million Dollar Slots winner. A casino makes money because it knows thateven though it will pay out huge sums periodically, it is collecting enough over time to cover thosewinners and then some. Page 2
How to Minimize Trading RiskThe next step in minimizing trading risk is identifying and understanding the monetary forms of risk.These include Trade Risk, Market Risk, Liquidity Risk, Strategy Risk, and Brokerage Risk. We willexplore each of these individually in the next section. But remember, it’s not enough to understandthese risks intellectually. A successful trader must possess the psychological makeup to acceptlosing without becoming emotional.Trade RiskAs you might have guessed, Trade Risk is the maximum amount of money you are willing to risk ina single trade. This is the form of risk you will become very intimate with, as you are accepting thisrisk every time you trade. Assuming the same 50/50 trading strategy used in our previous example,you know that the trade risk must be les than your average winner. But how to best reach thatfigure? A simple exercise practiced by successful traders before entering any trade.First, look at the price chart and examine supply and demand (prior price moves). Next, determinethe lowest acceptable price before considering the trade “broken” and exiting the trade. Set yourstop loss (protection exit) near this price. Finally, determine how many shares to buy based on thatper-share loss assumption.Typically, traders use a metric of 1% to 2% of available trading capital as the maximum percentageloss per trade (aka Trade Risk). The math looks like this: $30,000 in capital X 2% max loss = $600Trade Risk. If the price can move against you by $1 before you exit at your protective stop lossprice, then you should buy 600 shares. That’s it. Simple yet effective position sizing and riskmanagement.Market RiskThis is a relatively rare occurrence; however, you need to be prepared for it. Unlike Trade Risk, thisform of risk is uncontrollable. A terrorist attack destabilizes world markets and they plunge inminutes. War breaks out in the Middle East. You get the idea. These are big events that createadverse effects in the markets themselves. Smart traders prevent personal catastrophe fromMarket Risk by determining how much capital they are willing to lose relative to their net worth. Inother words, smart traders allocate a fraction of their capital to a Trading Account, and limit tradingto only that amount. An acceptable percentage is a very personal choice, but 5%, 10%, and even20% are the figures mentioned most often. The world may be coming to an end, but at least you’llhave some money left to enjoy the last few days!Liquidity Risk Page 3
How to Minimize Trading RiskThis risk is the inability to exit your trade due to lack of counterparty (the person or entity on theother side of your trade), and it’s generally preventable. Just be sure you’re trading highly liquidstocks (bonds, futures, currencies, commodities) on regulated exchanges. With many markets nowopen 24/5, you need to be aware of the liquidity at the time of day within the market you’re trading.Again, this is easily preventable by selecting only those trading times (for the given asset and yourposition size) that ensure you reasonable liquidity.Strategy RiskStrategy Risk is unavoidable and a result of volatility in the market. If you’re an educated traderyou are using a trading plan, and within that plan is a strategy or three. You know them very welland trade them regularly. Unfortunately, although your strategies may include 50/50 winners with a2:1 profit-to-loss ratio (as in our example) this performance is not consistent trade after trade, dayafter day. As with the coin-toss, there may be several losers in a row or several winners in a row.The best way to manage Strategy Risk is to set limits on your equity drawdowns (drop in accountvalue allocated to a specific strategy). If strategy “A” loses 20% over the course of a month, stoptrading it. Again, the percentage you use is up to you and the relative success of your otherstrategies. It is important to pay attention to the performance of each strategy independently andbe assertive about dumping one that isn’t working. You can always “paper trade” it until you seethe performance stabilize and then re-enter with real money.Brokerage RiskBrokerage Risk is rare but needs to be acknowledged. What are the chances of your broker goingout of business or robbing your account? Not great, but that’s because you’re probably thinking ofa brand name broker, like TD AmeriTrade or Charles Schwab. Be cautious about where you placeyour trading capital. Do your homework. Research the SEC web site for pending actions. Theindustry that comes to mind right now is spot Forex.You’ve seen plenty of ads about trading the world currency market, touted as “the largest tradingmarket in the world.” They boast of huge margins, no commissions, and making you richovernight, but beware. Spot Forex brokers generally do not give you access to the world currencymarket. They are usually the counterparty on the other side of your trade, which makes them nobetter than the corner bookie. However, to be fair, not all spot Forex brokers work like that. Thereare many that insure your account and minimize being your counterparty. Ask before opening youraccount. You can also open a futures brokerage account and trade currencies in that market,which is regulated and mature.The Ultimate Risk Hedge Page 4
How to Minimize Trading RiskGiven all the forms of risk in trading, many traders utilize hedging strategies to minimize theirexposure to adverse market conditions. Using Futures and Options as insurance policies againstmid- to long-term market positions might make sense for you. Of course, the cost of that insurancewill reduce your ultimate profit, but the peace of mind might be worth it.Here’s another risk hedge you may not have considered: Don’t trade, stay flat! Staying “in cash” isthe ultimate risk hedge; you can’t lose. Of course, the skeptics would argue that you are losingopportunity, and they would be right. But there are times when market conditions shout, “Don’ttrade now; keep your money safe!” Depending on your trading style, those conditions are evidentin times of extreme volatility, both high and low. The following table illustrates how trading style andvolatility relate, which in turn highlights when staying in cash might be your best move. Position Trading Swing Trading Day Trading Scalping (Long Term) (Intermediate) (Intraday) (Intraday)High Volatility Avoid Avoid Ideal IdealAvg Volatility Good Good Good FairLow Volatility Ideal Fair/Good Avoid AvoidThere are many ways to measure market volatility. One common and effective method is AverageTrue Range. Plot this indicator on the price chart of your asset and look back over time at the highand low volatility periods. Once you understand the relative ranges of that volatility you can avoidtrading the market/style that is most risky. Make this a “checklist item” in your trading plan andwatch your trading performance improve.In the end, it’s not how much you win, but how little you lose. The winners will always be there.Your timing is going to be correct plenty of the time and you’ll have many very profitable trades.What you don’t want and absolutely cannot afford to have is… the big loser.Attend our half-day, complimentary, Power Trading WorkshopIt is essential that you develop and follow a trading and investing plan that is tailored to yourspecific financial goals, risk tolerance and lifestyle. More importantly, you need the knowledge,skills, tools and resources to regularly update your plan going forward. Online Trading Academywould like to help you create that plan. You are invited to attend a complimentary half-day class inwhich you will learn… Page 5
How to Minimize Trading Risk • Volatility-based risk and trading strategies • How to safely short sell and earn fat returns when the market drops • How to buy stocks at “wholesale” prices, below the current quoted price • How to adjust your trading style to the market momentum • The 7 Pillars of Trading, contained in every great trading plan • Entry and exit timing tactics that will improve your returns up to 2x • Plus, you’ll witness a live trading session with one of our professional traders. You’ll watch as we trade live and call out the market action…This complimentary half-day class is limited to only 15 attendees for personalized attention to yourtrading and investing questions. Contact us for the current schedule:Tampa, Florida: (813) 933-4350, Tampa@TradingAcademy.comOur HeritageOnline Trading Academy’s roots can be traced back to 1997, as one of the largest trading floors inthe U.S.A., with 180 traders averaging half a billion dollars in daily transactions. To improve results,managers and the top traders offered daily coaching sessions to under-performing traders in howto trade more consistently and profitably.In 2001, we shifted our focus to solely providing education. Today we have a community of over29,000 students that have learned to trade with the skill and confidence of professional traders.We offer professional instruction in all of our state-of-the-art teaching facilities around the world.Classes cover a spectrum of trading styles and asset classes, including day trading, swing trading,position trading and investment theory for stocks, ETFs, options, futures, and currencies.Most of the classes we teach offer 100% tuition reimbursement from our broker/dealer partners.And, we are unique in integrating live trading in class, with all trading expenses (losses andcommissions) paid by us.As an Online Trading Academy student, you’ll become part of a community of active traderscommitted to succeed through continuously improving their professional skills. In fact, our liveclasses offer free “retakes” for life, giving you the opportunity to really “get it” and stay abreast ofmarket changes going forward.More Free Trading Resources 1. Join our free trading Meetup Group, Tampa Bay Market Traders, to share trading successes, challenges and Q&A with an Online Trading Academy Instructor. Register at www.meetup.com/TampaBayMarketTraders/. Page 6