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Risk management for new traders

The main trading room of the Tokyo Stock Excha...
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Daytrading seminars, trading books, television commentators and radio advertisements are filled with promises of easy money in the stock market. With just a little bit effort and a fistful of dollars, you too can be enjoying the lifestyle of the rich and famous.

We know in our hearts that this is not true and yet everyday people put their hard-earned money down on the hopes of finding their path to financial freedom in the stock market. This is the same feeling that sheep have on the way to being sheared.

You should remember that anytime you begin a new venture,  you are easy money and that you can expect to pay a price in time, effort and money to learn how to survive in the trading game.

Your education begins with an honest assessment of the kinds of risks you are likely to face. You should be writing a business plan as a trader in order to account for these risks and the way you intend to manage them, so that you have a fighting chance of breaking even in your first year as a traitor and then surviving long enough to learn how to make profits.

At a minimum you should at least consider how to address the following kinds of risks:

1. Psychological risks: these are the challenges that your ego, peer pressure and family situations can bring to trading. If you’re trading family money, or trading in public, or trading for any reason other than to make money to feed your family then you run the risk of getting in your own way with your poor psychology. The stock market acts in a way to cause the most pain to the most number of people based on herd psychology. If you do not work on your psychology than you will be a herd animal offering your money to the carnivores. Conduct self assessments into your strengths and weaknesses, take trader psychology profiles to determine what manner of strategy is best suited for your psychological makeup and conduct routine daily journaling to itemize your performance and learn from your mistakes.

2. Market risks: there’s no way to avoid the risk inherent in the market, because it is precisely the risk which provides the opportunity for reward. You therefore must become a master of the specific dynamics of the market you have chosen to trade. How volatile is it? Who are the major players? What are the cycles associated with the instruments you intend to trade? What are the rules for capitalization, leverage and clearing of trades? What are the seasonal risks associated with fewer trading targets?

3. System risks: these are the risks that are inherent in particular trading strategies that are designed to achieve an edge in certain markets. There are risks associated with mechanical trading systems, just as there are risks with intuitive or discretionary systems. Knowing your system well, means that you can identify the explicit risks as well as the implicit risks with each strategy. With a healthy dose of humble pie and a conservative nature you can work to minimize these risks.

4. The risk of nonlinear events: any system can be backtested long enough to give you a sense of how it should perform in the kinds of markets that have already occurred. The hidden risk of back testing is that you may experience discontinuous events which change the correlation numbers for your systems.  There are  portfolio engineers who study the past in order to find the relationships between different asset classes. When nonlinear events or catastrophes occur, it is normal for these historical correlations to change dramatically and you can find out where you thought you were hedged in fact you are double exposed.

The short list of risks only begins to scratch the surface of the kinds of challenges awaiting a traitor in the world of the equity markets. If this shortlist is intimidating then you have a fighting chance to be able to survive in your first year. If these risks don’t concern you at all,  chances are you’ll be seeking employment elsewhere.

Respect the game, respect the markets and acknowledge the real risks waiting for you on the road to financial freedom through daytrading. Good luck and good trading!

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  1. osamu
    May 25, 2010 at 12:20 pm

    Maybe, many people seem to be bored at their usual day-job, and want to see some “dream” in mkts. Trading-business is not so exciting, but a trader would be interested if he/she focuses on it. In my opinion, the point woud be comittment and continueing the business.

  1. May 25, 2010 at 12:25 am
  2. May 30, 2010 at 8:41 pm

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