I often hear my students comparing trading to driving. Having driven a car in at least 10 different countries, I have realized that there is truly a parallel between trading and driving. The last thing we want to do is have a crash in either! So how do we prevent that? Risk management is the key.
Most people think of stop losses as their only form of risk management. That is like thinking of air bags as your only form of protection in a collision. The air bag may prevent you from serious injury or death, but it is going to beat you up. Not to mention, the airbag only deployed at the moment of impact, it did nothing to prevent you from having the crash in the first place!
The same can be said for a stop loss order. The stop loss did not prevent you from losing in the trade. The only purpose for a stop loss is to keep those losses small and manageable when they do occur. So what can a trader do in order to manage their risk? Fortunately, like driving, there are several things.
The first is to get the proper training and gain experience. Think back to when you learned to drive. You may have had a parent or sibling or even a driving instructor show you the proper operation of the automobile and the rules of the road. Growing up in Eastern Pennsylvania, I just watched the boys at Pocono Raceway… maybe that explains some things.
Anyway, the proper education and mentoring helped to reduce your risk of danger on the road. The same educational and mentoring process is critical for traders too. A complete understanding of how the markets work and order handling specifics is important. Also needed is a solid comprehension of how to read price action on charts. This is what we teach at Online Trading Academy.
But were you a safe driver the first time you hit the roads even thou you were told what to do in the car? Probably not. With continued practice and mentoring you likely identified your weaknesses and improved. An apprenticeship like the Extended Learning Track is the equivalent for trading.
Once you gained experience in driving, you were more likely a safer driver. You can recognize dangers and try to avoid them. Recent inclement weather in the Mid-West and East Coast caused local and state officials to temporarily ban driving on the roads for the safety of the drivers. The officials recognized that the environment offered a great risk to those who may try to drive in it.
Risk management for traders is similar. We need to take trades that offer low risk, high profit potential and high probability. Analyzing the trading environment you are operating in allows you to avoid risky trading situations that could lead to loss. We should always be aware of trends, supply and demand, not just in the timeframe we are trading in but also in the larger timeframe.
When I drive, I am constantly scanning the road and my mirrors. I want to know if and where there may be danger. I do the same with my trading, looking at multiple timeframes, related securities and markets in an attempt to fully understand the trading environment I am in and to see where the dangers to my capital may be.
I was in Sturgis for the motorcycle rally last year with a couple of Online Trading Academy graduates. One (who will remain nameless), was leading our group and accidentally turned the wrong way down a one way street. I saw the immediate danger and dropped back after an attempt to signal him. Fortunately there was not any opposing traffic. But there was a local police officer! Because I saw the danger, I was able to turn quickly into a parking spot and avoided confrontation by the officer. The rest of the group was not so lucky.
If we ignore the dangers to our capital in trading, we run the risk of losing it. Risk management is simple. There are simple rules and steps to follow to increase your chances for success. Learn those rules and make your own decisions. Do not be blinded by what you hear on TV or the internet for your trading decisions or you will likely follow your money the wrong way down a one way street.
By the way, the officer let them go with just a warning and we all laughed about it later.