Friday, January 09, 2015

Growing Your Trading Risk: Three Common Mistakes

At some point, most skilled traders achieve a degree of success and seek to maximize the economic value of their trading.  This typically means taking more risk to achieve larger rewards, often by increasing the size of positions.  Here are three mistakes traders typically make in growing their risk taking:

1)  Increasing risk in excessive increments - We are paid in dollars, not in basis points of return on a notional portfolio size, so it's only natural for us to respond emotionally to the dollar P/L of our wins and losses.  When we increase our trading size dramatically, trades suddenly *feel* different and we create a situation in which drama can lead to trauma.  This is particularly common among developing traders who move from simulated trading to live trading with small accounts.  The position sizing relative to the size of their accounts creates excessive price movement sensitivity, even though the absolute value of the swings may not be enormous.  Very gradual but steady increases in risk taking allow us to accommodate to larger swings in P/L.  It is very important to not create a situation in which you have made profits on the year taking X risk and now give it all back by taking 2X or 3X risk.  No single set of expectable losses should be sufficient to impair one's subsequent decision making.

2)  Increasing risk at inopportune occasions - Many traders will increase their risk-taking by scaling into trades, starting with relatively small positions and then adding to those as the trades are going their way.  The problem with that approach is that, once the trades have moved in the trader's favor, the risk/reward is now different and often less.  This way of growing risk taking can subtly turn a trend trader into a momentum trader:  buying strength and selling weakness--especially when there is a fear of missing moves with the larger trading size.  Not all trending markets are momentum markets; many times you want to buy the dips during uptrends and the bounces during downtrends.  By adding risk as markets are at highs or lows, traders often ensure that they are most vulnerable to reversal when they are largest in the trades.

3)  Increasing risk subjectively - An exercise I've found very useful is to study one's past profitability based on the number of trades taken per day or week and based on the amount of risk taking over time.  Surprisingly often, traders perform their worst when they are trading their greatest risk.  Although they tell themselves that they have confidence in their trades, the larger size (and perhaps overconfidence) leads them to be less nimble and more stubborn in their trading.  This can lead to outsized losses.  It is not at all clear to me that most traders are good at knowing which of their trades are going to work, so that they can size those most aggressively.  Rather, if a trader's decisions have positive expected return over time, it can make sense to gradually size up each trade and not expose the account to occasional large drawdowns.

It is all too common that traders will take risk down after what are normal, expectable losses and then ramp risk up after normal, expectable runs of winning trades.  If each trade has a relatively uniform edge, such decision making dramatically lowers long-term returns.  Much of total trading returns comes, not just from the ideas traded, but how we pursue them.  Effective money management is a powerful tool for the management of the emotions of trading.

Further Reading:  The Psychology of Risk and Return