Wednesday, November 05, 2008

Coaching Yourself: When Should A Trader Cut Size/Risk?

A reader and excellent developing trader recently brought a dilemma to my attention:

"I had on a few different positions today. None were really working. However, I saw something that I liked. I only bought half size position. I think because my other positions were not working, I was hesitant to add more. I was proud of myself for getting involved and it was a great trade, but it could have been even better if I had a full size position. How can I get myself to think that each and every position is different and not worry about the current positions I am holding?"
This is a great question, but a proper answer requires more information. What does it mean that none of the positions "were really working"? Were they scratched trades? Losing trades? Big losing trades? Marginal winners? The answer to that question makes all the difference when it comes to sizing subsequent trades.

Every intraday trader needs to have--and enforce--a "drop dead" level for the day. That reflects the maximum loss you're willing to incur in a single day's trading. If you hit that level in a day, it tells you you're not seeing the market well and, like a pitcher on a bad outing, you need to get off the mound and call it a night.

In my own trading, I have--in addition to the drop dead level--a warning level that is roughly half of the maximum loss I'm willing to incur. If I hit that warning level, I drop my size (risk) and don't return to normal-size trading until I've worked my way out of the red for the day. By heeding the warning level and dropping my size, I give myself a chance to battle back. I also give myself an opportunity to participate in afternoon moves that could make my day. Dropping the size and waiting until I see markets well keeps me in the game.

(Some traders I work with have separate morning and afternoon drop dead levels, which also serves the function of keeping them in the game if their day starts poorly.)

With respect to the trader who asked the question, if the initial trades that weren't working were putting him in the red, near a warning or drop dead level, then reducing size was a prudent measure. Yes, it would have been nice to have had full size for the winning trade, but the alternative could have been a huge loss for the day that undoes a week's worth of profits. Trading smaller when you're in a hole and waiting to regain your feel for the market is always good self-coaching.

On the other hand, let's say that the initial trades didn't make money, but didn't lose either. To cut size at that point is to let the scratched trades create frustration and a loss of confidence. The experienced trader learns to love scratched trades. Not only do they show an ability to limit losses; they also can provide useful information. If I'm long the Spooz on a breakout move, the market moves my way, and then reverses hard back to my entry level, my scratched trade has just told me that there are plenty of sellers at the top end of the trading range. That very often can set up a nice fade, reversing my position to profit from the move back to the middle or bottom of the range.

When your trades aren't working and you're bleeding capital, you're just not seeing markets well. It pays to take a break from trading, figure out what you're doing wrong, and then return with small size to regain your feel. If your trades aren't working, but you're not losing much money, then you want to extract the information from those trades and see if you can develop some good ideas that you can express with normal size. A losing trade is not necessarily a bad trade. Indeed, it's the good trades (those with an edge, that have worked well in the past) that don't pay you out that offer some of the best information. If you're getting frustrated with your trades, you can't embrace them and learn from them.