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10 Things You Need to Know about Risk, Risk Management and Trading

Respect price, respect risk and always be prepared for any outcome. 

(Updated 3/11/24, originally published on 10/24/19).

1. Experienced, high-level investors and traders focus first on how much they can lose in a position and how to manage the risk.

Others tend to focus just on how much money they think they can make, with little or no consideration given to potential losses and how to manage them. Skilled traders know if they focus on protecting the downside, the upside will take care of itself. In a major index uptrend, it should not be very difficult to find uptrends and winning positions to get into. A quick scan of the new 52-week highs list shows very strong uptrends across the board. Getting into an uptrend is basic trading 101. Skilled traders let the upside trades go to work and focus on eliminating the losers that can cut into their equity.

2. Stocks and markets often go down faster than they go up.

The adage goes, that stocks take the stairs up and the elevator down. Fear and greed are the two emotions most prevalent in stock markets, and fear is the strongest of the two. It has been said that markets look their best at all time highs, which may be true, but they can also turn quickly. The S&P 500 bottomed in October of 2002 at 768, and by October of 2007, it topped out at 1576, a gain of over 105% in 5 years. By March of 2009, just 17 months later, it made a new low of 666. Five years on the way up (stairs), less than 1.5 years on the way down (elevator).

3. You will have losing trades.

Some of the greatest traders ever discuss being profitable on less than 50% of their trades. Paul Tudor Jones discusses strategies to be profitable being right just 1 in 5 attempts. George Soros has been said to have “maybe” a 30% to 50% win rate, by his former colleague Scott Bessent. The fact is that anyone who trades is going to have their share of losers. It doesn’t matter what your systems historical win rate is, how good the chart “looks” or what data you think you have, the very next position that you go into can move against you, it is an unavoidable fact. I go into every single position knowing that it can be stopped out at any time and size my account properly for overall risk and individual position risk. Once investors and traders accept that each and every position can go against them, it should allow them to prepare for the reality of it and try to minimize the damage.

4. You will have a string of losing trades.

To expound on the point above, any trader or system, over time, is going to run into a string of losing trades. Many greats discuss trading smaller when they hit these losing periods. By using fixed percentage risk sizing (risking the same percentage of account equity per trade) a trader ensures that they will be trading smaller in drawdowns and losing periods, because trade size is dictated by account equity. Lower equity means less dollars at risk per trade. As their performance improves, net trade size will increase in line with equity.
The key here is to be prepared for losing periods, to stick to the plan, and to not try to revenge trade their way out of a drawdown or losing period. Markets don’t beat traders, traders beat themselves because they try to impose their will on the market. That is 100% a losing proposition.

5. Most traders think they can mentally handle larger drawdowns than they really can.

My markets mentor taught me “investors can handle unlimited volatility…on the upside”. Many seem to feel like they can handle volatility as long as the market is trending in their direction and the P/L keeps creeping up. We are all brave with the wind at our backs. Once any significant pullback or drawdown happens and traders see their equity contract and the red days add up, many often panic and cut technically sound positions just to stop the pain of the drawdown. More often than not, markets turn around right after they flip the panic switch and the trade resumes its uptrend, without them in it. One great trader, whose names escapes me now, said that in realty traders can handle about one half of the drawdown that they think they can. Essentially if one thinks they can handle a 30% drawdown, they are really probably wired for about a 15% contraction. When your $100K account becomes an $80K account, or your $1 million account says $800,000, the reality of drawdowns sets in and most, if not all of us, wish we had dialed back the risk sooner.

6. Stop losses are essential, but they do not cap your risk.

Great traders know what gets them out of a position before they get into it. They ask two questions. How will I know that I am wrong and what will I do to minimize the damage? Soros and others are famous for being great loss takers, and cutting positions with zero remorse or hesitation when the market proves them wrong. Stop losses are a great way to minimize risk, but they do not put a cap on it. Positions, both long or short, can gap against a trader for any reason, or no reason, at any time. Careful position sizing should be used to calculate risk, but traders need to be prepared for a gap against them at any time, which can cause a losing trade to cost more than the trader initially planned for. Trading smaller in size than one thinks they should is one way to minimize the damage done by gaps through a stop.

7. Most traders overtrade and leave themselves overexposed in one or more ways.

Bruce Kovner, Billionaire Market Wizard, key advice to traders is “undertrade, undertrade, undertrade”. He said his experience with novice traders is “that they trade three to five times too big”. A detailed discussion of overtrading could take up an entire book. In my opinion, overtrading is the single most damaging thing a trader can do to their accounts. Overtrading does not just mean trading too frequently. It can also mean having too many open positions, too many correlated positions, having too much money at risk in positions or accounts as a whole, and taking on significantly more risk than they need to. While this may seem like a good idea on the way up, when they start to unwind the damage can be swift and severe.

8. The best true hedge is cash and reduced exposure.

Some think that they can counter long positions, and/or overexposure by hedging away risk using derivatives (options) or shorting techniques. While a 130/30 long/short strategy may sound great, it may not be the best approach for most. Some people make a living driving 200 miles per hour, but for most of us, that would likely result in a less than optimal outcome. Options do not always move the way they are expected to, due to a variety of variables and short positions can go up while long positions go down. I had this happen to me before years ago, and I noticed it was usually before Fed meetings. Then it occurred to me that traders may simply be closing out positions ahead of the Fed, which is why all of my positions went against me. I never confirmed it, but the theory did not seem unreasonable. I have watched levered short ETFs lose value while the market they were short was also losing value.

In times of extreme volatility or panic, all assets can decline in value as traders or funds have to sell anything liquid to raise cash and/or meet redemptions. Any hedging strategy that involves extra exposure may often result in extra risk. While I am sure someone can produce a statistical report that shows they have exceptions to this statement, the general concept applies. The absolute best hedges are cash and reduced exposure. Cash is cash and it doesn’t fluctuate in value.

9. Ignore predictions, forecasts and market calls.

I realized long ago that nobody can consistently call market moves. Being on TV or having hundreds of thousands of social media followers doesn’t guarantee accuracy. Predictions are generally no better than a coin toss and often worse. Incorrect predictions are swept under the rug, and when one lands right, it is often based on random chance. Traders often allow themselves to hold onto a losing position longer than they should, based on someone else’s opinion. I learned long ago to develop my own method for trading and investing, based on charts and technicals, which suits my timeframe and ability to deal with daily volatility.

10. Realize that any outcome is always possible, and that markets or stocks can pull back at any time for any reason, or for no reason at all.

For some reason, many believe that to invest or trade profitably they need to know “why” markets move the way the do. The fact is, we don’t always need to know “why”. Markets are made up of millions of participants and computers, all with a different process. Once we accept that markets can up go because they are and go down because they are, we can accept that not every move has to be explained or justified. Holding onto downtrends because the fundamentals are “good” or the chart “looks good”, and ignoring the fact that the trade is moving against you can be very costly.

Respect price, respect risk and always be prepared for any outcome. 

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