Taking on More Risk for More Reward

Mar 10, 2007: 12:23 PM CST

“No pain, no gain.” “No risk, no reward.” In order to achieve success and realize your dreams, you must take on risk and manage it properly, despite the biases of your previous experiences and your personality. Some of us love risk while others hate it.

Assuming the right amount of risk not only is difficult, but is very tricky. Assuming too much risk often leads to a depletion of capital and missing of key opportunities, while too little leads to unfulfillment and lack of potential profit when opportunities arise.

Finding the balance can be achieved using the following strategies:

  1. Work hard at understanding the basics of trading and market behavior (develop your own way to quantify market action)
  2. Have awareness and control over your own psychological contributions to the risk-taking process (how do you feel when you take on risk?)
  3. Practice and gain real-world experience through taking incrementally greater risks (start small and build up with early successes, rather than rushing in)

To take on risk successfully implies

  • acting outside the vicious cycle created by fear which wrecks havoc on your confidence and mental preparedness
  • creating goals and acting out of those goals, rather than temporary emotions which will inhibit you and soon pass
  • following an action plan outlined through personal study and research
  • overcoming internal inhibiting beliefs based on previous experience (cleansing yourself from the weight of negative memories)
  • managing assumed risk in an honest, open, and creative way

Ideally, you must arrive at the point where you choose your risk not out of fear or greed, but by creating a powerful, enabling framework of opportunity and excitement to execute your trading method. This would imply identifying what patterns you are most suited for trading (can recognize easily), taking each opportunity you see, and managing the risk of the trade by carefully designed methods that work for you and your risk-tolerance preference.

Scan only for the data points and situations that create market movement. Don’t bog yourself down in too much detail or overanalysis. Find “inflection points” or as I call them, “Technical Decision Nodes” where the market must move in one direction or the other, where other traders are watching these key spots along with you. Analyze what others are thinking and how their risk-taking behavior can help you determine your choice of action.

Find situations where your risk is low and your reward is high and have patience to wait for these opportunities to materialize. All you need to know is this key chart point and you can make money while others, overloaded with information, miss this sweet opportunity because they crave higher certainty.

People with less info in a focused way can be much more profitable than those with excessive information whose emphasis is on certainty and not results.


Anticipating a New Price Swing Lower: A Rare Prediction

Mar 8, 2007: 11:46 PM CST

I want to highlight the market principle “Momentum Precedes Price” by a past chart example and the possibility that we are seeing a similar set-up in the market. You know all the caveats about market advice; I am posting this for education – not for trading advice. First, let me post a daily chart of the Dow back in May, 2006 (Chart courtesy TradeStation).

  1. There is a slight momentum divergence (at the bottom) if you compare the swing highs in late February, late March, and late April with price. The oscillator is making lower highs while price makes higher highs. Price failure is expected to come.
  2. The first strong negative impulse occurred mid-May when the Dow fell from its swing high of 11,600 to a swing low of 11,100, erasing 500 points rapidly. Note the new momentum low (reading of -200 on the oscillator) – momentum precedes price, so after a counterswing up, expect a new price low.
  3. A counterswing up occurred at the start of June (from 11,100 to 11,300) where the market found resistance at the convergence of the 20 and 50 period moving averages. Your “new swing low” is now imminent. This setup a great, high probability short “large target” trade with a very tight stop.
  4. The expected new price low came as expected with a new swing leg lower, taking the market to 10,800.
  5. Note the easy to spot momentum divergence (to the BUY side) that occurred mid-June (oscillator makes higher low while price makes lower low).
  6. The new “swing low” leg was almost exactly the same distance as the previous swing low leg.

Of course, price rallied a bit, retested the lows, and then rallied strong from this point (until the recent shock decline).

Now, I want to point out a similar, ominous pattern in the current market (also in the S&P and Nasdaq).

Here are some observations on the current situation:

  1. We see similar momentum divergences in price swings leading to the recent decline (they’re difficult to read as the “swings” or volatility have contracted).
  2. Momentum still precedes price. Our recent decline took the Dow from above 12,750 down to 12,050, erasing 700 points. Please observe the impulse move and the clear and overwhelming new momentum low which took our oscillator to -300.
  3. Expect a counter-swing upwards and then expect a new price low following a new momentum low.
  4. Swings often occur in equal magnitude, so we can anticipate a possible “equal measure” swing low, which could take the Dow down to 11,800 or lower.

Consult your own research before making investment decisions. I have annotated this chart with the most likely price SWING. The annotations are my own.


Please check out March 8th Market Coments by TraderMike who suggests a similar theme, yet uses volume analysis (volume divergence with price) to hint at a similar prediction. Oda at Options the Easy Way provides a longer term Dow Chart analysis and nice picture of the S&P (SPY) and the similar declining volume on a rally theme as Mike indicates.

Regardless of the swing chart, please understand that the market is going to have a difficult time overcoming the declining 20 and 50 period daily moving averages. If anything, the convergence of those barriers should set up a strong, high probability shorting opportunity and chance to place a close stop just above the convergence zone and play for a large target of upwards of 600 Dow Points (with a stop 50 to 100 points above these averages). Trading is not about being right – it is about finding high probability opportunities and taking them, yet honoring your stop when your ideas are invalidated.

Remember, it is much easier to predict swings in the market, and not overall trends. And in trading, it is wise to know when you are wrong. My analysis will be invalidaded should the market trade above 12,400 and rise above that level. In that case, take your stop, and move on to the next trade. But odds are so strong for a new leg down that I had to post this (usually private) analysis, if for nothing but for a warning not to get aggressive on your long positions in this counter wave (which some TV pundits are calling a “bottom”. Calling? More like yelling at the top of their lungs).

Regardless of your approach or thoughts on the market, please be careful out there as the weeks ahead transpire. There is a lot of uncertainty in the market and please be mindful of that.


Quick Comment on Less Successful Traders

Mar 8, 2007: 10:10 AM CST

While thousands of posts and articles have been written on why traders are not achieving the success they desire (or worse, are failing), I wanted to point out three quick ideas that summarize behaviors that lead to failure in the market by newer traders.

  1. Traders play for large targets and “swing for the fences” and take on too much risk with too little information or knowledge
  2. Traders play for small targets when they should be playing for large targets and take on too little risk when odds are on their side and opportunities arise
  3. (New) Traders are more likely to be distracted by others’ opinions or their own emotions (overreactions) that occur when taking risk, or just pass on the trade

In a shorter summary:

  • New traders take on excessive risk when they shouldn’t
  • New traders don’t take enough risk when good opportunities arise
  • New traders let their responses to their emotions keep them on the sideline altogether.

Also, newer traders tend to be REACTIVE to market action when they should be PROACTIVE.

They often wait for confirmation of a move before entering, while professional traders – knowing odds are in their favor – enter moves before they begin. New traders are more likely to enter their trades at the end of a move. Watch yourself and try to attempt to move like a professional would, which often is the opposite of what your feelings are telling you to do.

Trading is a game of balance – in this example, between taking on too much risk and leading to failure (through excessive losses) and too little risk (leading to breaking even at best) where your time and risk do not result in profit. There is an optimal point in each individual trader regarding their risk tolerance level and maximum reward point. Success requires finding balance between excessive risk and excessive concern for loss. Only through constant monitoring and good record keeping – including personal observations of your emotions – can we find this balance point.

Sidepoint: I have experienced each of these extremes, as I’m sure nearly all traders have. My fault exists in not taking on enough risk, or staying on the sidelines when I should be in. It was taking on excessive risk (overleveraged) with overconfidence that developed my fear bias through a particularly bloody trade. Fear can develop like a food poisoning experience, where it can be very difficult to get back to where you were before the incident.

Many traders experience initial success, get burned a few times, then come back to the market in a fear mentality. Afterwards, they learn from others, then overcome the fear through small victories, and then the balance is achieved through repeated experience of actually trading the market. It is a difficult process with many pitfalls, but – as anyone can tell you – the rewards are well worth the journey!


Asking Empowering Questions

Mar 8, 2007: 9:55 AM CST

Do you run an internal dialog with yourself that oscillates between praise and criticism? Encouragement and discouragement?

While we can’t always stop this ‘inner critic,’ we can redirect its questions from negative criticism to positive encouragement with a few tactics.

First, you must identify your internal thoughts and call them to attention. What is that inner voice saying? Is it being helpful? Seek to quell any negative talk like: “If I buy here, they’ll gun my stop” or “I just lost money and I’d rather not trade right now because I’ll lose more” or “I always lose in the market.”

Instead, use your inner voice to ask empowering questions. It might be helpful to write out a list of questions that, when the answers are provided, move you closer to achieving your goal. Examples of empowering questions might be:

  • What additional work can I be doing to achieve my goal?
  • What more information do I need to know, without going too far (resulting in indecision)?
  • How long should I hold this position and should I play for a large or small target?
  • At what price (or condition) should I exit my trade early?
  • Is there anything I can learn from my emotional response during this trade?
  • What specifically is preventing me from achieving my goals (fears, overconfidence, lack of knowledge?)
  • What can I do to change my habits that are limiting me and attitudes that result in losses?

Asking these questions can help propel you to greater returns by laying a foundation for your actions and giving you more confidence because you know more now than if you did not undertake critical thinking.

Asking and answering empowering questions leads you to positive, proactive action rather than reaction to emotions or advice from others (or worse, inaction).

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The Five Outcomes of Any Trade

Mar 7, 2007: 10:41 AM CST

When you enter a trade, you expect prices to move in your favor and gain profit from your temporary assumption of risk. The outcome is not always profit, however, and losses can be very frustrating in the market. Even though human nature primes us to put more emphasis on current events (and outcomes), trading success hinges on probabilitstic thinking and creating a positive edge over many trades taken consistently through a proven trading method or system.

Realize that “you are not your trades.” You also are not your system or method. Studying the application of the five mathematical outcomes of any trade can lift your condifence and quell the psychological pain from focusing too much on recent outcomes from your trades.

After you enter a trade, you will experience one of five outcomes when you close that trade:

  1. You will experience a Large Profit
  2. You will experience a Small Profit
  3. You will “scratch” the trade for Break-even
  4. You will experience a Small Loss
  5. You will experience a Large Loss

Obviously, your system should be designed to allow you to capture large profits and small profits with a few break-even trades in there, right? Not in reality.

Realize that you will experiences losses in market speculation, and also realize that market professionals often have “win rates” less than 50% (they lose money on more than half of their total trades). Also realize that traders who have very high win rates (70% or higher) turn out to be break-even traders or losing traders at the end of the month or year.

How can this knowledge be comforting to you? Let’s apply cross-cancellation to the outcomes above.

If you consistently apply a system with good money management and discipline (defined as allowing trades room to run when playing for large targets AND cutting losses before they become large losses), then the following end-of-year result should occur even if you are a trader with a 50% win rate:

  • Small losses will be offset by small profits (leading to break-even results)
  • Break-even trades (scratches) will result in ‘break-even’ results
  • Large losses will be eliminated by proper utilization of stop-losses (excluding rare events such as violent gaps which will occur a few times through the year)

So according to our five outcomes, which one remains?

“You will experience large profits”

The above is a simple, mathematic explanation of probabilistic outcomes of your trades based on your trading system (which should be proven to have a positive edge and expectancy).

If we are left at the end of the year with “large profits,” then we traders with a positive edge should be profitable, right? Right, but that is not the end result in an industry where so many people fail.

People take their profits too early and hold on to losers. This skews the distribution graph negatively and “bleeds” mathematical edge away from the trader. Not only is the trader forfeiting large profits, but he is experiencing large losses that disciplined stop-loss behavior would eliminate.

In a simplistic conclusion, traders must hold on with conviction and play for large profits, and realize that small profits will only be offset by small losses. Large losses still may occur (due to sudden volatility or gaps), but they will be much fewer in frequency and will be offset by corresponding large profits. What will remain is other large profits that may come from a handful of trades, but will set the trader with a positive account over time, be it at the end of the month or the year.

Emotional Caveat: Most of the trades that result in large profits are entered in environments where most traders would not enter. A recent example would be the rampant negativity that we experienced in the 10% market decline of May-June 2006. The market increased 25% following the ‘bottom,’ but the technical and fundamental picture was so negative, that many traders refused to enter. Many times, not only do we ‘pass’ on trades that would have given us large profits, we do not press our edge and hold these trades EVEN IF we enter them.

We tend to trade where we feel comfortable and take our profits far too early. As exemplified above, if you only play for small targets, you can hope for break-even at best. Finding opportunities to play for large targets and use small targets to offset small losses (while guarding against large losses) should create a probability ‘outcome’ edge for success in trading.

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