Accepting Risk as a Trader

04/16/2010 12:01 am EST

Focus: STRATEGIES

Trading psychology is the most important aspect of a trader's success. I have made this statement before, but it is worth repeating. There are many factors that contribute to a trader's psychological makeup, and there is no easy way to attain a trader's mindset. However, there are certain factors that influence a trader's psychology that are important to be aware of. We recently published a feature that covered how a trader should deal with a drawdown (see “Trading Psychology: Dealing with a Drawdown”). That feature discussed the psychological implications of losing over a series of trades. Today's topic, accepting risk, pertains to individual trades rather than a long string of trades.

The best traders typically are the most consistent traders. In order to be a consistent trader, it is important to consistently apply one's methodology to the market and make as few errors as possible. A trading error is when a trader deviates from their methodology. Common errors include taking a bigger loss than planned, exiting a trade earlier than planned, taking a trade that does not fit the trader's usual criteria, or passing on a trade that fit the trader's usual criteria. These errors can be destructive to a trader's capital and sanity.

Trading errors are usually induced by emotions caused by previous trades. The most dangerous emotional catalyst (in my opinion) occurs when a trader loses a trade they felt was a certain winner. After losing this trade, a trader feels sad, angry, or even vengeful against the market. This causes a trader to enter a trade irrationally in order to win back what they felt they were cheated out of. Of course, this trade is usually a loser too. If it wins, this can be even worse, because it encourages this type of decision making in the future, which could lead to even larger losses.

In my opinion, the reason the aforementioned scenario is common among traders is that they did not accept the risk when they placed the trade. They thought the trade was a sure winner, so it was miserable to take the trade as a loss. In fact, traders may even refuse to take their loss because they were so sure it was a winner, which can lead to devastating losses. This is why traders must accept the risk of each trade before they enter their position. In other words, a trader must view the amount of money they are risking as an expense to see if their trade idea will work. Once a trader accepts the risk, they will typically feel far less distress if the trade does indeed lose.

Accepting the risk of each trade is not easy, especially for inexperienced traders. Of course, there are some steps we can take to make it easier to accept the risk. First, it is very important to plan out each trade. This means we should know where we will enter the trade, place our stop, and place our take profit level(s). That way there are no decisions that need to be made once the position is entered. The human brain will view information differently once that position is entered, and it thinks much more clearly before the position is entered. Additionally, if we know the distance between the entry and the stop, we know exactly how much capital we are risking. This is important because it is impossible to accept a risk when we do not know how large the risk is. After entering the pre-planned trade, emotion is inevitable, but at least it won't impact the result of the trade.

As we said earlier, a trader must view the amount of money they are risking as an expense to see if their trade idea will work. Every trader has losses. However, consistent traders view losses as business expenses. Losses are a necessary aspect of trading, and there is no way to know which trades will win or which will lose when the trade is entered. Therefore, if we can accept the risk of each trade before placing it, these losses can more easily be viewed as part of trading, rather than a personal attack from the market. Once a trader learns to accept the risk on every trade and concedes that they don't know which trades will win, it will be much easier to control one's emotions and achieve consistent results.

By Bradley W. Gareiss, contributor, FX360.com

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