Saturday, March 01, 2014

The Importance of Psychological Risk Management

The function of risk management is not only to preserve your capital; it's also to protect your emotional well-being.  Traumatic responses to market losses are the unacknowledged dark underbelly of trading.  As I suggested a while ago, few in the trading industry find it in their interest to discourage overtrading.  If anything, the emphasis is on apps and ubiquitous links to make it ever easier to place trades.  I have yet to find newsletter writers who will pound the table and emphasize that there is little opportunity in the current market.  That is not the message readers want to hear if they want to trade--and you always have to please the customer...

Here's a nice checklist that covers some of the signs of trauma that I've seen among traders.  No, that trauma is rarely at the level that one would see in the full-blown post-traumatic responses of war veterans.  Rather, it's more subtle, as in overreacting to small drawdowns after having taken large losses, finding one's mood rising and falling with P/L, and impaired risk-taking.  

Oversizing one's positions and portfolio creates drama and drama can lead to trauma.  If your trading is truly planned, with maximum losses anticipated and wholly acceptable, there should be little drama in your trading.  Yes, drawdowns will be disappointing and annoying, but they will not throw you emotionally.  They will not impair your next round of trades.

If you have experienced a drawdown and are finding it emotionally difficult to come back, you know that your psychological risk-taking has been excessive.  Ideally, you want to be learning from your losses, not reeling from them.  Risk management keeps you in the game financially, but also psychologically.

As I mentioned in the last post, Naomi (above) came to us as a traumatized kitten.  She could not tolerate being near people.  I can only guess what had happened in her past.  Now she is a sultry beauty who sits next to me on the kitchen island while I respond to mail and research markets.  How did she make that transition?  The next post will look at ways of overcoming traumatic responses--in markets, and in other areas of life.

Further reading:  Finding Opportunity in Adversity 


gratalis said...

Risks and costs associated with excessive trading are the main reasons I switched from trading the ES contract outright to the ES weekly futures options. Nothing illustrated the problem more clearly than the excessive trading costs shown here in yellow. Trading has been much more successful (steady profits as opposed to steady losses) and much less stressful since switching to weekly options.

SSK said...

PART 1: Hello Brett, A nice link in the article that points to the check list. I would say that regarding question number 4, 5, and 6…looking back at some of my recordings from past trading days, there were many times I would get stopped out to the tick, and you could picture in your mind’s eye and hear the emotions on the tape, nothing that was really overreacting for the most part though, in time with those instances, I could actually laugh at how that was possible! That though, lead to one of my strong points, and I had a very good track record in separating what could be called revenge trading, from identifying times where the stop was just a bit close and all the other data I was looking at still corroborated the validity of the initial trading idea, so getting back in was no problem. However I do remember strings of days of losses, in which I would have to decrease my contract load by sometimes many contracts. I noticed that I would then think about what caused that drawdown quite a bit, even during times of other activities (entertainment) that should have been focused on relaxing and enjoying the moment. None the less, none of those events were ever catastrophic. I have mostly been able to look back in my records when faced with such a losing streak and gain efficacy and bounce back, remembering that those king of events have happened in the past, and being able to see the results afterwards helped immensely in, keeping mostly level headed in big winning streaks and moderate losing streaks. Regarding question 6, absolutely, that was the catalyst for my brief therapy goal snippets project that was a great project, but I need to get back to it. There were categories such as cognitive dissonance and lack of…hastiness and lack of…impulsiveness and lack of… patience and lack of…discipline and the lack of…revenge trading and lack of…insights into trading behavior based on changes in intonation, apathy, etc. A huge project that I would like to get back to. It took a lot of time due to all the editing that was required, and all the information during the day to flag, so you could produce a good video, but on the few that were produced, you could see the confusion, dissonance, puzzlement clearly, and you could compare those times when there were not. Regarding question 7, I would say yes, but earlier in my trading process before I started understanding psychology and how the mind and body work together. Most of the other questions, we no, or mostly no.

SSK said...

PART 2: In your other link on Position sizing and risk management in trading…You bring up some interesting stats. According to your research 1 contract per 10k in the account with my type of stops, (depending on if I am day trading or trading on the weekly’s) are more than 1%. That again though in my case, has not been destructive. Maybe that is because of a decent spread (over 3000 day trades the spread was 2 to 1, and the win rate was at least 65 percent, a bit higher in high volatility markets. When I was trading the weekly’s, I didn’t keep formal records, but I do remember that during rotating markets, I was not doing well and decided to stop the action all together because there were to many family obligations at the time, and I realized my process was severely compromised. I think I remember reading this post in 08, and tried the risk per day for a bit, but that for me seemed like it took my strength away…That didn’t lead to anything good in my case, as another strong point of mine was clawing back from loses within the day frame that according to my 1 contract per 10k, that on quite a few days were way above the 1%, probably closer to 5%. Additionally I was not a victim of revenge trading for the most part, just not as advanced in understanding market structure and tactics as I am now. Overall back then, I remember drawdowns of 20% in the account, but again, in their wake, never left me with destructive behavioral influences. Rather they acted like a catalyst to understand what was happening. None the less, I will see how I can take a look at those metrics again in the future without compromising any strengths. Thanks, Best, SSK