Everything You Needed to Know About Trading You Learned in Kindergarten (Part 2)

04/21/2009 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

Always Consider the Consequences of Your Actions

Some people are not built right emotionally to be successful traders, but then, some people are not built right emotionally to be successful writers, and most people are not built right physically to be NBA stars! But many people that try their hands at becoming successful traders are not getting all the help that is available to them.

Public perception is part of the problem. You would amazed to hear how many people think they can read one book or watch one video and then make money trading against the rest of the world, which includes the best traders in the world. Let's face it, there is no “beginner's league” in trading—we all swim in the same water! I tell people who ask me how difficult it is to become a trader that they should think of it as getting a quality high school and university education. I don't mean it will take seven or eight years, but they need a solid foundation followed by some deep discovery to find their own trading talents, and then they need to develop their own specialization. Once they have found an area of trading they like and might be good at, they need to master the tools of their trade. And of course, did I mention the need to be adequately funded? I am going to leave the question of the minimum amount needed in a trading account to realistically expect to make a living from your trading for another article, but every person considering trying their hand at trading should realize that the smaller their initial account, the less room for errors they have. And the last thing a new trader needs is the pressure not to lose.

But there are things traders can do to take pressure off themselves, cues they can adopt to help get on a winning run and shorten their losing runs, or at least minimize the effects of their series of losses. In my mentoring sessions, one of the things I teach after getting to know a new student is a set of tools that will force them to limit their losses, and equally important, reward them when they really have a nice day.

Let me tell you how it works: If you normally risk $150 per contract per trade and you are trading one contract each time you trade, you should be choosing your trades so that they have a risk/reward ratio of at least two dollars gained for every dollar risked. This means that on average, if you are risking $150 on every trade, your winning trades should average at least $300 at the end of each month. This is simple bottom line risk/reward analysis. If your monthly risk/reward is higher than 2:1 and you make winning trades 50% of the time, you are well on your way to being a profitable trader—but you're not there yet!

Now that we have your risk reward target, we need to talk about maximum sized losses versus maximum sized gains. When I begin to plan out a trade, I use a visual cue that helps me stay within the loss parameters I have set for myself. I view my trading account as a checking account, and when I am planning my trade and filling out my trade sheet (which I always do before I enter any trade), I literally write a check out in the air, right in front of myself, for the amount, per contract, that the potential trade will cost my trading account if my stop loss is reached. If the check that I write out is for an amount more than what is my maximum acceptable loss on any trade, per contract, I do not take the trade. The act of writing the check out in the air forces me to confront the size of the potential loss before the trade is entered.

And writing this check before each trade is entered has an added benefit: As I write the check, I simply consider that I have just spent that amount, per contract, out of my trading account. I assume that money is gone, even before the trade is entered! Sound crazy?

By assuming the stop loss money is gone, I have also dealt with any emotions associated with the trade if it turns into a loser: I've already lost that money, right? But if it turns into a winning trade, I not only get the profits I accrue in the trade, but I get the initial stop loss money check back as an added bonus! I know it sounds crazy, and believe me, when I first started writing out stop loss checks in the air at the proprietary trading room I run in downtown Chicago, the other four traders used to scratch their heads or shrug their shoulders because they thought I was crazy, too. But after watching me do it for a few weeks, they started doing their own version: One of them literally had checks printed out and he writes out a check while considering a trade; another has a check form built into his trade sheet, so he goes through the same ritual right on his trade sheet. Try it. You might find it helps you limit the size of your losses, and also makes it easier to deal with your losses.

More tomorrow in Part 3.

I wish you all good trading.

Timothy Morge
"Master your tools, Master Yourself."®

timmorge@gmail.com
www.medianline.com
www.marketgeometry.com

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