The biggest danger for any trader is excessive exposure. An unexpected price spike can then trigger a margin call that wipes out all the profits generated over months of hard effort. This is the most frequent reason why traders lose money. How can we prevent this from happening? What do we have to know?
Diversification
As there is no such thing as perfect foresight and an unexpected price spike can occur at any time, a trader should always diversify his risk and trade not just one, but two or three ideas at the same time. It is through diversification that he can improve his risk profile – when one trading idea is in the profit, the other runs a loss and vice versa. Overall his performance is smoother and more importantly, this approach reduces the pressure to perform. The trader is then more relaxed and less emotional in managing the exposure of his trades.
How to realize profits?
Whatever the underlying trading ideas are, the method for converting an idea into a realized profit is always quite similar. First, the trader should define a budget in terms of assets that he intends to commit to the trading idea. It is best to divide the budget into targeted position size and additional capacity that he intends to use in case that the market turns against him. I advise that the targeted position size should be only one third of the overall budget of the trading idea – a large two thirds are additional capacity that is kept in reserve. When he opens his position based on his trading idea, he should split the initial trade into three tranches, because there is no way to know the optimal timing for an opening a trade, so it is better to diversify this risk into three opening trades.
How to manage a trade?
In the blog on why butterflies cause cascading margin calls I explained that a trader needs to be on the continuous lookout for unforeseen events that can trigger a cascade of margin calls. When this happens, any trade can turn into a losing position, where the entry price is so far from the current price level that the profit target is out of reach.
Improving price average to turn losing position into a profit
A losing position can be turned into a winning trade by turning the negative development into a positive and take advantage of the new price level to add to the existing position thus improving the price average of the whole position. In doing so, the trader shortens the distance between price average and current price thus increasing the likelihood of a price bounce that is sufficiently large to turn his position into a profit.
Why are price rebounds bound to occur?
In liquid financial markets up to 98% of all the trading is based on speculative positions and the hedging of those positions. These positions being speculative are temporary and any opening trade will need to be closed. When the closing trade happens, this has the effect of inducing a price reversal. Due to the duality of the opening and closing trade the price movements are never fully one sided. At some stage, sooner or later, positions will be closed and then the price rebounds occur.
A trader can use these reversals to turn a losing trade into a winning position. The method of increasing the position size to turn a losing trade into a winning position has, however, big drawbacks, which the trader has to be fully aware off.
Smoke and mirrors
Human beings do not find it easy to correctly identify price extremes. They typically interpret relatively small price moves as extremes, where in actual effect the moves are only moderately larger than average. This deficiency is even more pronounced when a trader faces mounting losses. When under pressure, the trader’s internal clock ticks faster and he poles the market price at a higher frequency. Time will seem to flow more slowly, minutes will feel like hours and days like weeks. Under these circumstances, the trader’s natural instinct is to time his trades in terms of his internal clock, but this is wrong. Unaware he will focus on smaller-scale price movements that are out of step with his overall trading strategy. He will decide to increase his bet too early. There might be a bounce back, but this will not be enough for him to exit his position with a profit. If the price resumes its slide, the trader will accumulate losses even faster than before because of the larger position.
A trader needs to take into account that his sense of timing is skewed when under pressure: he needs to lean back and slow his natural instinct and wait for a price overshoot that is in sync with his regular trading frequency. Patience is of essence.
Reducing position size
If a trader has increased his position size to improve the average price of his position, he has to reduce the size of his position at the next opportunity, when the price rebounds. This is important because he has to free up margin capital, so that he can increase his position, when the price falls back again. By carefully managing the position size during the ups and downs in the price, he earns incremental profit that turns a losing position into a winning trade.
Trader deep freeze
The biggest danger for a trader is the so-called ‘deep freeze’ mode: a trader, who is close to a margin call, freezes up and does not have the mental energy to take decisions and blindly hopes for a price rebound. He can be lucky once, twice or three times, but not on an ongoing basis. Similar to a mouse that is hunted by a cat and cannot move for fright, the same happens to the trader. It is important to preempt this situation. The trader has to set himself a stop loss, where he will get out of his position, whatever may happen. Ideally, the stop loss is never triggered and he is able to maneuver out of any unrealized loss by increasing and decreasing his position size in response to the local highs and lows of the market. In case he fails, he has to have a stop loss strategy in place that limits his overall risk. It is all too easy to close one’s eyes and hope for the best.
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How to trade: managing exposure
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