Protection Against Risk

Making a profit in the trading world is hardly a sure thing. How you deal with this fact of trading, though, depends on your personality. Some people take risks in stride, while others obsess over them. Which type of person are you, a natural born risk taker or an obsessive, fearful seeker of safety?

Life is a matter of taking risks, but some people embrace it while others superstitiously try to avoid it. For example, have you ever seen an extremely ineffective car theft device called "The Club?" One is fooled into believing that by putting a massive metal bar on your car steering wheel, you are protected. It seems like it would work until you realize it takes merely a few minutes to cut the steering wheel with a hacksaw and pull it off. Similarly, why do car stereos have removable faceplates? Do you think thieves are actually unaware that there isn't an expensive stereo beneath a removed faceplate? These kinds of "protective" devices make us feel better, at least until we realize that they don't work. At that point, we think, "How could I have been so stupid?"

Feeling protected helps take the edge off. Even if it is just superstitious behavior, like wearing your lucky shirt on the day of a big trade, you feel better when you do it. There's a psychological benefit to it.

We can alleviate some of the uneasiness of taking risks through risk control. By risking a small percentage of our trading capital on a single trade, and looking at the big picture, you will feel more at ease. From a psychological viewpoint it is to your advantage to make a potential trading loss so insignificant that you may start thinking, "Why am I even bothering making this trade?" There is no universal rule for how to limit risk. Some experts suggest risking merely 2% of your capital, while others suggest 5%, and still others suggest using past market action to determine the amount of loss you can afford to take (for example, if the market is bullish with many opportunities for profit, then you can take a little more risk.)

The best way to control risk is to set a protective stop, but whether or not you set a stop loss or how you do it depends on your personality and attitude toward risk. If you are a natural born risk taker, you may not set a formal stop loss at all. You may keep an informal stop loss point in mind and close your position when prices reach that point. At the other extreme, the obsessive-compulsive, worrier trader may set the stop loss too close to the entry price and end up getting stopped out too early.

The middle ground seems to be reasonable for most traders. Again, it depends on your personality, but if you are afraid to take a loss, a stop loss can help. If you don't have a stop loss and hate taking a loss, you may not close out a position when the price falls hard. You may be prone to hope against hope that the trade will turn around, and watch your losses mount as you fail to take action. The stop loss order, however, guarantees that you will be out of the trade at some price if the market moves against you.

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