T H E L O S E R 's S P I R A L - T H E D A R K S I D E O F T R A D I N G
[May 2001 Update: This is as true as it ever was - no edits required! We would be the last to claim that trading is not risky -- it can be quite risky, and usually is! All depends upon how you trade. Proceed with caution, and be aware of this phenonmena.
I originally posted this mid-99 on the "Daytrading Fundamentals" thread. The point is, if you're not systematically excersizing good loss control on every trade, you ARE going to blow out - sooner or later... probably sooner. The sooner you learn it, the better! Good money management is really the essence of successful trading.
Brandon ("Trading on Main Street") also has some excellent posts about Money Management. We'll be doing a 90-minute mini-seminar on it in the near future].
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All of us, as trader's normally sense that trading can become "dangerous", if you let it get out of control when it's not going well. It can indeed be a rather dangerous (risky) endeavor, financially speaking. A friend of mine, after trading marginally successfully for a few months, said to me "man, I sense this is really dangerous - I could get into a lot of trouble here". He was right. There is one basic process that destroys almost everyone that "blows out" of trading; I call it "the loser's spiral". I know all about it, as I went through it myself several times, in the process of really learning how to trade more consistently. Only extreme interest in trading, and perseverance through travails got me through this one! I've never met a good trader who hasn't been through grappling with this, either. As one well-known educator likes to say (quite rightly), "you must learn how to lose, before you can win". It is "the filter", which keeps most away from full-time, long-term trading success.
It goes something like this (simplified, for brevity). Trader makes a little bit of money. Skills develop. Trader makes a lot of money. Takes bigger risks. Things going well. Then...Wham! Big loss. Wham! Bigger loss. Trader tries to "make back" loss by taking bigger risks... and so on. The spiral is self-perpetuating.
Think that won't happen to you? Well, it happens to 80%+ of beginning traders within six to nine months (mileage varies, depending upon prevailing market conditions). It happens to a lot of intermediate traders, and experienced traders. It happens to world-class traders who run huge hedge funds, and it happens to people that have written scholarly books (Victor N.) and who are geniuses. So don't think it can't happen to you - it will, unless you study the mathematics of money management, and carefully calculate how much you can risk, versus your total tradeable capital. The statistics are overwhelmingly against you, if you violate the cardinal rules (generally, if you are risking more than 1-5% per trade, depending upon your trading style). You should also not have more than 20% of your trading capital/buying power tied up in any one trade. For those with more capital to trade, more tolerance for risk, more diversification, or a longer time frame, (usually a combination of these factors) the parameters are a bit different. But the basic idea is, if you are trading too "large" (of risk on each trade), sooner or later it will destroy you and blow you out of the game - probably, sooner rather than later.
Picture the trading process as a vortex that you are swimming in. If you trade properly and exercise good money management, you can create enough centrifical momentum to avoid the inevitable "flush down the drain". After a while, it will become a habit, and you will be able to routinely stay out of trouble (see my post on Equity Curve - an "early warning system"). But the forces of the vortex are always there, ready and lurking. This is truly the dark side of trading, which is always there. If you let your greed get the better of you, it will take over. And for any trader who has experienced the "high" of a big trade, the lure is always there to pull you away from your discipline. In this business, the pigs do indeed get slaughtered - always.
What causes a trader to enter into "the loser's spiral"? For most, it can be identified as simply to trading too big relative to their account size, trading without stops, and/or riding losing positions. Losses overwhelm gains, then the trader tries to trade his/her way out, quickly, often while not taking the true market environment into account before taking positions. Good traders are out of the market more than they are in, and they trade selectively.
Only the minority know how to avoid this vortex, in my experience. Think about it, before you commit to a trading (vs. investing) style... investors are less susceptible to this ever-lurking, rarely-discussed problem, which is the biggest potential pitfall traders must face, IMO. The shorter the time frame of your trading, the more difficult the trading process becomes. The potential return on capital also becomes higher; however the risks become higher as well. So daytraders, swingtraders, and position traders are particularly susceptible.
Good trading, -Steve |
