Trading is not really about prediction or being right or wrong. It is really about how much are you willing to risk to find out. It’s easy to take the approach of, ‘is this trade going to work or not’, and in reality, we can’t help but think that way on a certain level. But because we will never know before hand, and because protecting capital is rule number one, we must attend to risk management and have flexible expectations instead of thinking in terms of ‘prediction’.
Trading is a game of risk and returns. The balance between them defines your trading style and your chances of success. This is also where the main problem lies. The first question on a beginner trader’s mind is how much I can win on this trade. That’s the wrong attitude. It should always be, how much can I lose? Trading risk management helps maximize your potential gains while also minimizing your potential losses.
The Main Difference Between The Successful And The Unsuccessful Traders Is The Quality Of Their Risk Management Strategy. A Good Trading Plan Outline Includes:
Which Financial Instruments To Focus,
When To Enter And To Exit Trades,
Where To Set Our Profit And Loss Limits,
How To Determine Useful Or Useless Opportunities,
What To Do When The Markets Turn Against Us,
How To Deal With Our Emotions In Relation To Trading,
What Precautions To Take To Ensure We Will Stick To This Plan.
The primary reason to have a trading strategy that incorporates a risk management element is to stop you, the trader making poor decisions that are based on emotions, rather than facts and proven strategy. The best plan or strategy is doomed to failure unless it is adhered to, and emotions can get in the way. Hence the reason to have a strict trading strategy that defines when, how and where you enter, manage and exit trades. This obedience to a plan is core to any successful trading approach, to eliminate unnecessary and disruptive emotional and psychological influences and is why a risk management strategy is so important.
A set-up with a 50% win rate does not mean that the next 6 out of 10 trades will be winners . An objective market statistic based upon the past can not become a market probability about the future unless the same exact market participants are present and continue to act in the same way. Each trade, and each moment in the market, is unique for this reason.
The main point here is that although entry location is important, its how much we are willing to risk that determines our account equity and consistency over time.
If the primary focus is on whether the trade is going to be right or wrong, the trader is beginning to go down the slippery slope of market prediction. Trading is not a business of predicting, it is a business that involves hypothesizing and risk management. The biggest and best traders understand the distinction between predicting versus hypothesizing and also understand that risk management is critical. The job of a short-term trader is to be prepared to act in your own best interest when price approaches a level that you have determined to be important for some reason.
According to legendary trader Ed Seykota, there are three rules to successful trading, and each one is “cut your losses.” One common rule of thumb, particularly for day traders, is never to risk losing more than 1% of your portfolio on any single trade. That way you can suffer a string of losses—always a risk, given random distribution of results—and not do too much damage to your trading account.
In the final analysis, it could be said that good traders develop appropriate or realistic hypotheses and are good risk managers. Whereas, ‘predicting’ is what the typical unprofitable trader tries to do.