For readers who haven’t been following this series of posts, it makes sense to read these posts first:
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When people talk of the values of real estate, as in flats or parcels of land etc, one often hears the words, Location, Location, Location - the context is that the value of the asset is most dependent upon where it is located, nothing else matters.
When we are trading in the stock market, there are a lot of things that one has to get right, but if there is one thing that one just cannot afford to be wrong about, it is Risk Management. And no matter how many trading gurus you study, what stands out is that all of them, without exception, concur on the fact that risk management is the most important part about the trading game.
In the stock market, there are multiple ways to make money. If you study all the gurus, the manner in which Buffett has achieved success differs greatly from the manner in which George Soros has. However, if one were to invert that question and ask or study the manner in which traders have lost money, then that is a finite number. That is another way of saying that we should take care of our losses and let the profits manage themselves.
So, let’s cut to the chase.
1. Don’t trade when you can’t afford to lose. Play defence; not offence. Don't focus on making money, focus on protecting what you have. It is imperative to know what you don't know. No matter what information you have, no matter what you are doing, you can be wrong. The two lessons are: (a) if you never bet your lifestyle, nothing bad will ever happen and (b) if you know the worst potential outcome, it gives you tremendous freedom.
2. While trading stocks, we can't quantify reward, but we can quantify risk. A good trader’s job is to take losses. A prudent Risk Management System (RMS) ensures that we can always step aside and come back later. The overarching principle being that the stock market is an infinite game, and it goes on regardless of who is taking part. We don’t have to be a participant at all times.
2. Never hold a position that gaps sharply against you right after you've put it on.
3. Before putting on the trade, ask yourself: 'If this trade goes wrong, how do I get out?' Losses are a very important part of trading. When one is losing, the best strategy is to book the loss. By booking a loss, one can adapt one’s risk appetite accordingly. By definition, we must place a greater emphasis on loss avoidance, than on scoring gains. Every time one loses money, consider it as a learning opportunity; view the loss as a tuition fee at the ‘University of Trading.’ As long as you learn something from the loss, it's not really a loss. Absolute loss amounts in rupee terms, have to be predetermined, and acted upon, no excuses.
4. Don’t give your losses too much rope, don’t be in a hurry to take profits. When trading large position sizes, one must have a short fuse, unless the position is in the money almost immediately. The idea is to stay in the game, not to get rich instantaneously. We should keep on reducing our trade size when one is on a losing streak.
5. If you don’t understand the price action, or your position is not behaving in the way it should, get out. When in doubt, get out. And one has to do this irrespective of whether one is winning or losing. A flying analogy might be useful. It is better to be on the ground and wishing that we were in the air, than to be in the air and wishing that we were on the ground.
6. Don’t think about what the market is going to do. Think of what you’re going to do if the market actually does what you think it will do. So, don’t think of the idealistic scenarios in which the market goes your way. Think of those things that you want least to happen and on what your response should be.
7. George Soros is probably one of the best loss takers in the world. He doesn’t care about whether he wins or loses on a trade. If a trade doesn’t work, he is confident enough about his ability to win on other trades. Hence, he effortlessly walks away from his losing positions - this requires a lot of emotional fortitude and readers shouldn't think this is easy. Most of us find this to be insurmountable, and such people shouldn't take part in the trading game.
8. When we are booking losses, the idea is to minimise the INR amount of the loss. This has got nothing to do with how much you can afford to lose. For every rupee lost, losing an opportunity in terms of ‘dry powder’ gets reduced. Preserving optionality by booking losses is what all prudent traders internalise. The larger the rupee value of the loss, the more harm it does on our mental attitude and trading size.
9. Planning where you get out before putting on a trade is a means of enforcing emotional discipline. We lose our sense of objectivity the moment we enter a trade.
10. Never, I repeat, never average losing positions. If you are in a boat and that boat springs a leak, you don't want to drill another hole to let the water out, do you? Don't get bigger when you're wrong.
11. Always focus on controlling the downside; take your losses quickly. You can always put the trade back on. The most important thing about making money is not letting your losses get out of hand.
12. When you are buying into weakness, or selling into strength, don't put on a full position. Probe to see if this is indeed the market low (or high), keep probing.
13. A popcorn trade is one in which you had a profit and you rode it all the way back to where you got it in. Just like a kernel of corn pops, goes up to the top of the canister, and then falls all the way back down to the bottom. Popcorn trades are pretty common and that is because the second leg of the transaction (depending on whether we buy first or sell first) is the critical leg. When we are investing, the BUY trade precedes the SELL trade, and that means the SELL trade is far more difficult than the BUY trade. Similarly, while trading, the second leg of the trade, in most cases this is when we are booking profits (since losses have already been booked), is the more difficult leg of the transaction. Too many Popcorn trades are akin to a game of snakes and ladders, wherein one gets eaten by the snake when the goal post is visible.
14. Risk management at the portfolio level - limiting the loss on individual trades is critical, but it is not sufficient for adequate risk control. Traders also need to be concerned about the correlation between their positions. If we are trading significantly correlated unique positions, then the portfolio risk may be unacceptably high, even if every position has stop protection, because different trades will lose money together.
15. Using stop losses is a very subjective concept and there can be no one size that fits all. How one uses the concept of a stop loss matters little, as long as one ensures we limit the rupee value of our losses. The secret for winning in the stock market does not include being right all the time. You should be able to win even if you're right only half the time. The key is to lose the least amount of money possible when one is wrong and maximise the gain when one is right.
16. Hope is not a strategy. One has to get into trades that one thinks will work and not into trades that one hopes will work. The moment you realise that you're relying on hope and not trading, assess your position.
17. One should never fear the market, and if you make a mistake, don't complicate it. Just get out. Only by thinking independently can a trader hope to know when a trade isn't working. If you ever get tempted to seek someone else's opinion, it is a sure sign that you need to get out of your position.
18. There are two parts to any trade - direction and timing. If you're wrong on either, you're wrong about the trade.
19. If you speculate with a loss, to get less of a loss, you get more of a loss. Similarly, back to back ‘revenge trades’, with the sole purpose of ‘recovering’ lost capital, seldom work.
20. It is also virtually impossible to succeed at trading if you depend on trading profits to pay your living expenses. Many of us have a pay check mentality; we feel that we have to make a certain amount every month. You may go through long periods when you make nothing, or even have a drawdown, and then have a substantial gain. This reality is hard to accept, because we want to make a steady income from trading, but it doesn't work that way.
21. Take a day off after a winning trade; winning streaks lead to complacency and complacency leads to sloppy trading. Ditto for losing streaks. If your trading losses are because of poor decision-making, take a day off. It’s not about being right, it is about making money.
22. Having a quote machine is like having a slot machine on your desk - you end up feeding it all day long.
23. Beware of ‘Whipsaw Markets’ - ones in which prices swing widely back and forth, causing trend following traders to be positioned wrong, right before the market abruptly reverses direction.
24. Who said that markets are supposed to make sense? The market is not about facts; it's about people’s opinions and positions. Anything can trade at any price (remember, oil went negative in April 2020). Hence, having protective stops is imperative. (A similar situation arose in Copper very recently, but it was averted by policy action by the bourse. For those who want to read about the lack of consistency in policy action by two different international commodity bourses, click Doctor Copper is Sick)
25. If the price action is inconsistent with the trade hypothesis, don't stand in the way. Instead, try to form a new hypothesis that is consistent with the price action.