September 27, 2006 at 1:49 pm | | Comments 5

HOPE is Not a Trading Strategy

He is the Wiz, and nobody beats him.

It’s true – I’m a huge Market Wizards fan. All 3 of these interview-style trading books by Jack Schwager are excellent, and they continue to teach and remind me of highly important lessons about trading. My copies are all marked up with underlines, highlights, and margin notes, and I seem to add more every time I open them up.

Recently, I ran across a great quote by Larry Hite in Market Wizards:

“First, if you never bet your lifestyle, from a trading standpoint, nothing bad will ever happen to you. Second, if you know what the worst possible outcome is, it gives you tremendous freedom. The truth is that, while you can’t quantify reward, you can quantify risk.”

What a nice, basic concept. Know your risk…..on every trade, at any given time.

I know a trader who’s struggling to follow this advice right now. After getting caught on the wrong side of the market a few times in recent weeks, he’s suffered a series of tremendous setbacks. He isn’t quantifying his risk – now he’s only thinking of the rewards….praying he can recover from it quickly. As a result, he is swinging for the fences and hoping for a miracle. I’m afraid it’s just a matter of time before he’s right back to square one and looking for another trading stake. I’ve expressed my concern to him, but it’s a decision he’s going to have to make for himself.

HOPE is not a trading strategy! The market doesn’t care what side you’re on, and it has far greater staying power than you do. Arguing with the market is a futile endeavor, so the best we can do is to quantify our risk before putting trades on, and once our stop loss levels are hit we’ve gotta exit. The hard part isn’t knowing when you’re wrong (your P&L will tell you at all times). The hard part is replacing that hope of a miracle with the resolve to take action and stop losing (they call them ‘stop loss’ orders for a reason!).

It is easier to put a giant dent in your trading account when you’re trading with leverage. Futures, options, and even just day trading margin in a stock account can greatly accelerate losses compared to just trading a handful of stocks well within your buying power. Be sure you understand the risks you’re taking, because trading with leverage will compound your errors and bring the pain even faster.

We can all heed Hite’s advice, whether trading well or poorly. It’s timeless and it’s dead on. How can you argue with the idea of knowing your downside? You might be a part-time trader looking to make some extra cash on the side and possibly become a full-time trader one day. Or, you might already be a full-time trader. Regardless, the idea is to keep yourself in the game. Don’t blow out your account. Quantify your risk on every trade, and survive whatever the market throws at you. We’re all going to be wrong at times…..just don’t stay wrong when you know it’s time to bail out.

Jeff White
President, The Stock Bandit, Inc.
Find out how I quantify my risk here.

[tags]Stocks, Investing, Stock Trading, Trading, Stop Loss, Market Wizards[/tags]

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