Saturday, March 21, 2009

Learning How to Trade: Managing the Psychological Risks

A couple of years ago, I posted an article (now available as a PDF) on managing the psychological risks of trading. I encourage you to review that article; it offers an important perspective for those learning how to trade.

The financial risks of trading are fairly well known: If we size positions too large or incur too many runs of losing trades, our capital will become depleted. Lose half your money and suddenly you have to double your remaining capital just to return to breakeven. If you trade every day and average 55% winning trades, you'll incur runs of four consecutive losing trades roughly every month. Size those trades too large and you'll be looking for a new vocation or avocation.

(Another article in PDF worth reviewing is Henry Carstens' Introduction to Testing Trading Ideas. Even if you're a discretionary trader, knowing your typical win ratio, average loss size, average drawdown, etc. helps you gauge your financial risks).

When you are learning to trade, those financial risks turn into psychological ones quite quickly. We might have a 55% win ratio, but we don't know how that 55% will be distributed over time. Consider Henry's P/L forecaster illustrated above. We have a small trader with a $33,000 account who has an average win equal to their average loss ($1000 per week after commissions) and a 55% winning percentage. The above chart shows one possible path for their two-year (100 week) P/L.

Overall, the trader is quite successful. The two-year return on capital is 33%, enough to support a career in the portfolio management world. But note that the first 15 weeks are spent in the red. Moreover, there is a drawdown late in the period in which nearly one-third of profits are lost. These adverse events--entirely expectable and having nothing to do with altered or poor trading--create many of the psychological risks of trading.

Most new traders, facing 15 weeks in the red, will change what they do, abandoning profitable trading methods. Many more, facing a profit drawdown, will shut down or change their methods, again drifting from their strengths. The resilient trader learns to expect these setbacks as a normal part of doing business. No matter how good you are--and I work with some very good traders--you will have extended periods in the red. The psychological risk for those learning to trade is not that you'll lose your money--proper position sizing and risk management can prevent that-- but that you'll lose your nerve. Just because you have an edge doesn't mean it won't feel at times like you're on the ledge.