From the December 01, 2007 issue of Futures Magazine • Subscribe!

Risk management is key to day-trading

If you want to know something about the fallout from poor risk management, consider this personal account.

In 1987, I lost everything.

On Oct. 19, 1987, my life was rosy. I was a vice president of a major brokerage firm. The family was doing great. I had a nice house, cars and other amenities that a cushy income could provide. By the time I crawled back under the covers that same evening, however, I was broke. The Dow Jones Industrial Average had plummeted more than 500 points, losing approximately 22% of its total value. Across the board in the United States and around the world, the financial markets took a nosedive. My portfolio crashed with them.

I was heavily invested in options. On Thursday, Oct. 15, 1987, I was long 1,000 S&P 100 puts, but I was also short 1,000 S&P 100 puts. I had some protection because the short position offset the long one. The offsetting positions were supposed to be my insurance against calamity.

However, all of that changed on the following day, Friday, Oct. 16 when my long positions expired. The short positions still had a month to go. That left me with naked options; in other words, they had no cover. I had sold 1,000 puts that I did not own and I had guaranteed a buyer that I would deliver if the strike price was hit.

On Black Monday, the strike price was hit and I had to produce. I was forced to buy them at a high market price, even though the market was dropping like a ton of bricks. If I had been able to hold my long puts for one more week, I would have made millions of dollars, but in October 1987, the market did not wait for me. I was a couple of days late and a thousand puts short.

It took me years to recover from the crash of 1987. I suffered a huge financial loss, but I endured an even greater psychological one. I lost faith in the markets, and I lost faith in myself. Over many months and several years, I worked to understand the mistakes I had made and to formulate a trading strategy that minimized risk. Today, I am a much different trader than I was before Wall Street taught me that hard lesson. I respect risk.

If you respect and manage risk, the rewards will come. Risk management is the skill that separates the winners from the losers. Everybody makes losing trades. Those who manage their risk cut losses quickly and preserve capital. The others let a few bad trades empty their accounts.

RISK CONTROL TECHNIQUES

There are several ways you can manage risk. First, know your personal risk tolerance. You must have a good idea of the maximum exposure that you are willing to take. Likewise, to apply that self-knowledge, you’ll need to calculate the risk of a trade before you take it. Determine the maximum amount of money that could be lost on the trade and honestly ask yourself if you are willing to accept it. If so, consider the trade; if not, walk away.

One great characteristic of the financial markets is there is always another trade. In a few hours or days, there will be another chance to make a trade that better fits your particular risk parameters. Be patient and wait for it.

A day trader, of course, generally makes a lot of trades. Therefore, day traders must manage every trade carefully. That means always using a protective stop and knowing when a loser will be liquidated. It’s not a bad idea, for purposes of risk management, to live by the cardinal rule to never trade without a stop. Bottom line, when you assume a position, place a stop loss.

Before making the trade, identify the point at which the market will make clear that the trade is wrong. For example, if buying an S&P contract at 1472.00 and the charts suggest that support should step in at 1469.00; place a protective stop at 1468.50. The reason is simple: If that stop is hit, the market has demonstrated loud and clear that the original analysis was wrong. Take the small loss and gracefully go to the sidelines. Another opportunity will come along soon enough—and maybe immediately in the opposite direction of your original trade (see: “When to say quit,” below).

Not only do you want to know your risk tolerance, but you also want to know what to expect from your trading style. For example, if you do a lot of momentum trading, that is, you look for market opportunities when market momentum will move prices quickly up or down for a short distance, you should expect to be paid quickly. Intraday momentum trades might require profits in a few minutes if they are valid. If they aren’t showing any, check your indicators and reanalyze. If there’s no clear reason to continue the trade, exit and wait.

Do not over trade. The biggest weakness of most traders is a lack of patience. They sit in front of their computer screens waiting to trade. Because they have planned to trade, they do so. They are not discriminating enough, jumping in and out of the market continuously.

Remember, every time a trade is made, a risk is assumed. Therefore, one of the easiest ways to reduce risk is not to over trade. Have a workable and tested strategy. Know the market setup that supports that strategy and be patient. Chances are, if you are making more than five or six trades a day, then you are over trading. Take only those trades that look really good, those that meet all of the parameters of your strategy. Otherwise, the bad trades will deplete all of the money you made on your good trades.

To help end over trading, adopt this simple rule: Three strikes and you’re out. If you make three bad trades in a row, even if you manage the trades well and suffer only a small loss, close your trading platform and walk away. Something is wrong. You are off your game. Either the market is tricky and not following the rules, or some other problem exists. At any rate, do not trade in a market that is taking your money.

SELF PRESERVATION

There’s some truth to the cliché that if you take care of the downside, the upside will take care of itself. Along those lines, always focus on preserving capital. While an all-or-nothing strategy might pay off big from time to time, it will not last in the long run. That is, if you make a trade and hold your positions until the maximum profit target is hit, you will do extremely well sometimes, but end up with nothing most times.

Instead, scale in and out of some contracts or positions at various profit levels. This approach is known as the 3Ts of Trading. In simple terms, it describes trading in multiples of three. When you enter a trade, know your profit targets and enter your orders to liquidate some positions at those targets.

A good first target would be only a few ticks from entry. Take, say, one-third or so of the position off the table. If the trade continues to work, exit another portion when the second profit target is reached. At this point, assume you have made enough money to cover the downside of the remaining positions. You are then free to either liquidate the last portion of the trade with the profits made, or you can place a protective stop at a breakeven point and let the balance ride (see “The 3Ts,” below).

Trading is not easy. It demands good analysis, good execution and good risk management. Those who succeed in the game are those who manage every trade and continuously respect risk.

BALANCING FEAR AND GREED

Psychology plays a huge role in trading. Many traders understand how to trade and could be highly profitable, but they continuously shoot themselves in the foot by being emotionally unbalanced. Regardless of your self-control, as a trader, there are two big emotions that you know all too well: fear and greed. These two forces impair analysis and keep traders from doing their best.

Greed leads to seeing money in every setup. Greedy traders trade too often and take far too many risks. Even when winning trades are made, these traders often end up losing money because they do not take reasonable profits. They want huge profits. Therefore, they keep holding positions until the market shifts and a winner becomes a loser.

The primal human emotion of greed is just one reason you should consider forcing yourself to take profits at various pre-planned levels. It keeps greed in check. It allows for a portion of the position to ride for maximum profits while taking smaller profits along the way to reduce risk and put money in the bank.

Fear has the opposite effect of greed. Traders make too few trades. They see the setup, they know it meets their criteria and is in line with their strategy, but they fear losing. Fear keeps them from making the trade and from making money.

Another aspect of fear is that it leads traders to exit winners too quickly. If one indicator goes against them, they bail. It is good to get out of losers quickly, but give yourself time to analyze what is happening. Risk management works both ways. A trader needs to get out when his risk limits are hit and needs to give each trade a chance to hit its profit target in the prescribed timeframe. A trader who is too fearful will never take risks and he will never make money. Winning traders put the odds on their side. They do their analysis, have a strategy and execute it as planned. They understand when the odds shift and are no longer in their favor and that is the time to exit the position.

Again, one of the best techniques for balancing fear and greed is the 3Ts approach. Trade in multiples of three and take profits at various profit levels. The first profit target will be just a few ticks from entry. The second profit target could be generally a point or so higher. Finally, the final portion of the trade is either liquidated with a

little more profit or it is left in the market to follow the daily trend and maximize profits.

The 3Ts approach concedes to fear and quickly reduces risk while pocketing some cash. But it also gives greed its due. Once you have exited the first two portions of the trade, the final portion is allowed to ride and take all it can out of the day’s market trend. This risk management technique allows you to maximize profits while also reducing risk. It helps create that delicate balance of fear and greed.

Tom Busby is a 30-year professional trader and Founder of DTI, a trading school in Mobile, Ala. Busby is a member of the CME and CBOT and has been seen on Bloomberg, CNBC and BNN. For more on Busby go to www.dtitrader.com.

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