April 19, 2011

Learning from the Masters of Risk

Extracted from the book: Inside the Mind of the Turtles, Turtle trader Curtis Faith

 Here are the seven rules great traders use to manage risk and uncertainly. They are

1. Overcome fear
Great traders know that fear can choke our decision process and cause us to avoid taking risks. Fear also can paralyze you when you need to act quickly and decisively to save yourself from danger---the deer-in-the -headlights syndrome. All great traders have mastered their fears adn are able to act decisively when needed.

2. Remain flexible.
As a trader, you never know which stock or which market may make a move. This is the essence of uncertainty. You don't know what is going to happen. When you don't know what is going to happen, the best strategy is to be ready for anything.

3. Take reasoned risks.
Many beginners trade like they are sitting at a Las Vegas craps table. They put too much money at risk, and they trade based on hunches,rumors, or someone else's advice. They take foolish risks. Great traders take reasoned risks. A reasoned risk is more like an educated guess than a roll of the dice. Great traders are not gamblers.

4. Prepare to be wrong
If you don't know what the future will bring and you choose a trade that assumes a particular outcome, you are possibly going to be wrong. Depending on the type of trade, in many cases it can even be more likely that you will lose money than that you will win money. What matters in the end is the total money won and lost, not whether you are right more often than wrong. Great traders are comfortable making decisions when they know they could be wrong.

5. Actively seek reality
As a trader, nothing is more important than an accurate picture of reality. Traders know that their decisions will result in losses. They also know that they need to know about these losses as soon as possible. A focus on what the market actually does, the market's reality, keeps successful traders from burying their heads in the sand and pretending that the world is other than it actually is.

6. Respond quickly to change
Just as important as actively seeking reality and facing that reality is doing something when that reality is not what you wanted, when the uncertain future brings the unhoped-for. When the market moves to price levels that a trader has previously determined would be the place to get out of a trade---by selling what he bought previously, for example---a competent trader will respond quickly and get out, thereby reducing his exposure to continued uncertainty to zero.

7. Focus on decisions, not outcomes
One of the reasons that great traders can so easily reverse course is that they have a more sophisticated view of the meaning of error for decisions made under uncertainty. They understand that the fact that things did not turn out the way they had hoped does not necessarily mean that taking the trade was a mistake. They know that many times good ideas don't work out. The very presence of uncertainty ensures that you will be wrong some of the time. All great traders put trades on for a particular reason, and they take them off for a particular reason too. Great traders focus on the reasons for the trades instead of the outcomes for a few given trades.

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