Friday, March 24, 2006

Observations on Trading Fundamentals and Risk Management

One of the interesting aspects of writing my current book on trader performance is interviewing people who have long years of experience as traders and as mentors to traders. To a person, they emphasize that success in trading is not a function of finding better indicators or trading patterns. Rather, they emphasize the seemingly mundane aspects of trading mechanics: sticking to trading plans, managing risk, and adapting to changing market conditions.

While the historical patterns on this site are useful food for thought and a worthwhile starting point for framing market understandings--and trade ideas, they cannot substitute for the fundamentals emphasized by these mentors.

Of these, risk management is perhaps the most important. Victor Niederhoffer, in his excellent book The Education of a Speculator, uses the example of trying to make $10.00 from $1.00 when you have a 60/40 chance of winning a dollar from each individual bet. The odds of ruin in such a game are about 66%. Indeed, one would need a bankroll in excess of $4.00 to make the pursuit of $10.00 a worthwhile game--even with 60/40 odds.

The moral of the story is that good odds aren't enough. Proper position sizing--and a bankroll sufficient to weather the inevitable strings of losses that occur with chance--are all-important. I have seen more psychological problems created by poor money management than the reverse. Losses should not be traumatic--emotionally or financially--if they are built into the trading plan and kept to a very reasonable fixed fraction of portfolio size.

No comments: