Imagine you are a medieval warrior…kind of like those guys from Lord of the Rings. (Hopefully you didn't picture yourself as Legolas.) You are facing your greatest foe, the villain known as Mother Market. She stands before you holding the biggest baddest sword you have ever seen, but thats ok because you are wielding the mighty…oops, never mind you only have a rusty dagger in your hand! Sounds like a bad dream, but this is the battle many traders face every day trading smaller accounts against hidden opponents with vast amounts of buying power. While all traders must overcome great odds in becoming successful at their craft, those that do so with a small account face even greater odds as they are fighting the markets without the benefit of a strong weapon (lots of cash). Luckily, small traders do have tactics they can rely on to help them overcome their bigger stronger foes. Educating traders on these strategies will be the main focus of this blog. (These stategies work for all account sizes, so don't feel this information would be useless to you if you are fortunate enough to have what you would consider a large account. Besides, against Goldman Sachs we are all small fries!)
In poker, a player with a relatively small amount of chips is considered to be playing with the short stack. Because he doesn't have a lot of chips in his corner, he has little chance of bluffing his way out of a pot and his raises are unlikely to deter opponents invested in the hand with significantly larger amounts of capital. Therefore, this player must become increasingly selective of the hands he will play and must be willing to play them aggressively hoping to take a bunch of small pots while having the odds in his favor in the event that he gets called or pushed into going all in by one of the bigger stacks. However, in trading the player has the advantage of not having to play until he gets the setup he wants and never has to go all in. In fact, he doesn't have to ante up, pay the blinds, or call raises. He even has the option of getting up, grabbing his chips and walking away from the table in the middle of the hand if he feels like it. Imagine playing poker like that! In essence, that is what trading the shortstack should be. You wait for pocket aces, you put a reasonable amount of chips in, and you see how the cards play out. If you get subpar cards, you throw them out and keep waiting for pocket aces. After all, why play anything else if it doesn't cost you to keep waiting for only the best hands? As a trader, you must do the same thing by using the chart setups that have produced strong results for you in the past instead of randomly jumping in and out of trades you see on twitter or hear about from friends. Dictating the terms of engagement is essential in any confict, and that is what you are forcing upon the market when you patiently wait for your best opportunities and ignore all subpar setups.
So now that you have forced Mother Market to face you on your terms, how exactly do you protect yourself against her? The first thing you need to do is get the best armor possible; sound risk management. If ever there was a holy grail to trading, this is it. Every successful trader I have ever heard of is an expert at managing their risk. The amazing part, is that managing risk is logically one of the simplest parts of trading. Figure out a reasonable amount of money you are willing to lose on an idea. Figure out the amount of money you would like to potentially earn if your idea works out and then implement that idea. As long as you always attempt to make more money than you are putting in you should be fine as long as your success rate approaches that of random chance. Understandably, managing risk is also one of the hardest feats for a trader to accomplish because of the interference caused by our greed/fear impulses. Overcoming these impulses and trading methodically is without a doubt the most important skill any trader can ever develop.
So how does a trader overcome the natural emotions of fear and greed while he is trading? He eliminates them by putting into place a trading system that allows him to make his trading decisions objectively by following guidelines that are predetermined by the paramaters he chooses. If this is done correctly, all possible outcomes are accounted for before a trade is made, allowing the trader to not have to make a decision in the heat of the moment when they may not be thinking objectively. In the Stockguy22 chat room, we are always talking about trading like a robot because that is the ideal mentality to have when entering and exiting positions. You should be entering,modifying and exiting positions based solely on logical decisions you have made before the trade is placed, not shooting from the hip like some crazy cowboy. Once you have a sound risk management strategy and the discipline to follow it, Mother Market’s strongest blows will barely harm you.
Stay tuned for the next installment of this series, in which we will go in depth on how to design a risk management plan that suits your needs.
if you have any questions or comments feel free to contact me on twitter @stockdarts