Commodities

It’s Too Late After the House Burns Down

dondawson
Don Dawson
Instructor

As I write this I am in beautiful Dubai where I am instructing the Professional Futures class. The entire Dubai Online Trading Academy staff has been very supportive and welcoming. The students are bright and eager to learn, making for a wonderful week in the classroom. I would invite any of our graduates to attend a class here and enjoy some of the wonderful adventures in Dubai as you learn to trade the financial markets.

Recently I received an email from a reader inquiring about the maximum dollar loss per day a trader should have.  It’s not often I get emails regarding this topic and that is a little concerning.  Managing risk as a speculator is just as if not more important than learning how to trade.  After all, you can have the best trading strategy in the world, but if you have poor risk management you will not survive trading the Financial markets.

One of his paragraphs read:

“My concern is setting the daily max loss correctly, so as to allow you to trade enough.  Set it too low and you have to quit too early before the market has a chance to give you time to recover.  Set it too high and you could end up losing too much on a losing day when the circuit breaker is tripped.”

He also went on to say that in his opinion the daily max loss should not be just an emotional risk tolerance decision.  I would say this statement would depend on each trader’s personality.  For some traders they will need a more quantitative rule to tell them to stop trading for the day.  While other traders can use a max loss that will allow them to sleep at night, basically an emotional risk tolerance.

Let’s discuss what this maximum daily loss is and then outline some ideas of how a trader might create their own personal number.

The nature of trading is that all speculators will have losing days, both pro and novice alike.  The difference between the pro and the novice is that the pro knows when he is having a bad day and will stop trading.  This allows him to conserve his capital and come back tomorrow to trade when the markets might be more conducive to giving him some winning trades.  The novice trader however will keep trading on losing days and will sometimes trade their account into the ground, basically lose all of their trading capital.  They will then be forced to stop trading until they can raise enough capital to open another trading account.

If you are familiar with household electricity you will know that each home has a circuit breaker panel that all the electricity in the house runs through.  This circuit breaker is to protect the house from catching on fire and burning down in case there is a short circuit in the electrical system.  Many a lives have been saved by these circuit breakers.

In trading we also need this type of circuit breaker, but it is used to protect our financial house.  The importance of knowing when to stop trading on a losing day cannot be emphasized enough.  There are many variables that cause even the best trader to have a losing day:

  • Markets are not conducive to the traders style (extreme or very low volatility can cause this)
  • Trader is having physical health conditions that will not allow them to focus on their trading decisions as they should
  • Perhaps a trader is having personal problems with their family or spouse that is leading to distractions
  • Maybe they are having problems with their job causing them to lose their trading focus
  • Technical issues – intermittent internet, computer crashes, software issues etc.
  • A recent financial loss in the markets that they have not mentally recovered from yet

And the list goes on and on…

The point is that you cannot focus 100% on your trading that particular day when you are having these issues affecting you.  This is where you need a rule in your trading plan that tells you if you lose a certain dollar amount during the trading session that you MUST stop trading for the day.  This rule in your trading plan and you having the discipline to follow it will be one of the most important steps in learning to trade that you can take.

Once you have established this maximum dollar loss per day (circuit breaker) you should always be subtracting this amount from your gross closed profits for the day.  For example, if your circuit breaker is $500 and you have no winning trades that day you will simply stop trading when your closed profit/loss for the day reflects you have lost $500.

If you have been trading and making money during the day you will take the maximum gross closed profit you have made that day and subtract your maximum loss from it.  Many traders make the mistake of waiting for their closed profit/loss to reflect -$500 before they stop trading.  But what if you had already made profits of $300 that day?  If you wait until your profit/loss reflects -$500 you have actually lost $800 not $500.

You can create your own equity trailing stop for each day by always knowing what your gross profits are for the day and subtracting your circuit breaker amount from that value.  This way the market will tell you when to stop trading and you won’t have to use an emotional decision as to when to walk away.  There will be trading days where the market wants to give you a lot of money and there will be days when the market wants to take a lot of your money.  By using the equity trailing stop you will protect a good portion of your capital.

Here are a few suggestions for coming up with your own personal circuit breaker:

  1. Pick a dollar amount you can lose and know that something is wrong that day and your trading is not working well.  This number will also be a number that will still allow you to sleep that night and you will not turn into an emotional angry revenge monster because you lost that much.  The loss will still sting, but it won’t ruin your personal life that evening or weekend.
  2. If you are day trading and the day trade margin is $1,200 then that could be your breaker also.  Find out what your broker charges for day trade margin and that becomes your daily circuit breaker.  Do not use this rule when brokers charge full carry margin due to extreme market volatility.  This occurred during the Silver market rally to $50 when the overnight and day trade margin was raised to approximately $29,000.
  3. Use a percentage of your account.  We usually use 1 – 2% per trade so you might look at using 3 – 5% of your account for a circuit breaker if you want to give the market some room for the day.  Preferably closer to the 3% level is better.  I have found that if you lose a lot of money in the morning then it is rare you are going to get it back later in the day.  So the smaller your circuit breaker the better in my opinion, but as my reader stated you still need to give the market room for a comeback later.
  4. If you have been trading for a while and you have some winning trades you can take an average of your winning trades to compute your circuit breaker.  You can average the last week, month or quarter of profits (personal preference) and then use 50% of this value as your circuit breaker.  Again, you may want to use 25% or some other variable of your winning trades.  Experiment with some numbers until you find a percentage you are comfortable with.

As I stated earlier all traders will have losing days.  I still hit my circuit breaker about once every other month if I am day trading frequently.  Like you I don’t like to lose this much money and then stop for the day, but I know the consequences if I don’t stop.  To me I don’t care why I lost that money while I am still sitting in my office.  I just know something is not working and the reason is not important at the moment.  The important decision is that I must stop trading.  My trading plan calls for all monitors to be turned off and that I must physically leave my office.  I did not have that discipline in my early days of trading some 25 years ago and I paid the price many times.  Today when I hit my circuit breaker I do as my plan says.  Later that evening I take myself out to the nicest dinner and finest bottle of wine I can get and reward myself for having the discipline to follow my rules to stop trading on losing days.  Later I will evaluate what possibly went wrong and if I need to correct something I will do so before I trade again.  Most of the time I find it was just market conditions were not conducive to my trading style that day.

I hope you find this article useful enough that you too come up with your own personal financial house circuit breaker because it really is too late after the house burns down.

Best wishes from Dubai,

Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.