Thursday, February 21, 2008

Mastering Trading Anxiety With Risk Management

In my recent post, I took a look at the nature and source of anxiety experienced by traders. There are many cognitive and behavioral methods that are quite effective in dampening anxiety, but this post will focus on a different strategy: preventing anxiety from occurring in the first place.

You might be thinking, "How is it possible to prevent anxiety when trading? After all, we can't control what the markets are going to do!"

While it's true that we can't control markets, it's equally the case that we can *always* limit the losses we take in any given trade (or any given week or month). We control the maximum amound we're willing to lose by three means:

1) Defining the maximum size position we're willing to take;

2) Defining the stop point at which we exit the trade;

3) Defining the amount of money we're willing to lose in a particular period of time before we reduce our risk.

The first two rules define our position risk: how much we're willing to lose in the pursuit of a particular gain. The third rule is part of defining our portfolio risk: how much we're willing to draw down in our accounts before we pull back, reassess, and limit further exposure.

Psychologically, the key is to formulate these rules in such a manner that they kick in *before* anxiety overtakes us. Recall that anxiety is a response to perceived threat. Emotionally, we want losses and drawdowns to be normal, non-threatening occurrences. They may be disappointing, but they need not pose threats to our emotional and financial well-being. Properly defined position and portfolio rules for risk management are preventive tools with respect to anxiety and trauma.

Look at it this way: every trader has stop limits for positions and portfolios. You will exit the market either because of the limits imposed by your rules or because of the limits of your pain. Risk management is the best preventive therapy of all.


Overcoming Performance Anxiety