Behind the Rules

Say you're a trader that has a tendency to have big blow-up days. You've got a decent edge that makes you profitable for most trading sessions, but that one time you lose the handle you'll end up giving back much more than just your recent profits. This is a cycle that seems to repeat itself far too often, and out of sheer frustration you've decided once and for all to get past this problem and begin investigating ways to go about doing that.

How about sweeping out any profits you have at the end of each week, so you won't be able to give it back when D-Day comes? This is probably your worst choice, for it does nothing but side-step the issue. Worse yet, you've practically set the clock ticking down to your next blow-up day by resigning yourself to its impending arrival, only this time you'll have even less equity in your account afterwards. In any case, it's probably a safe bet to say that your profits aren't the cause of the problem to begin with.

What about setting a daily loss limit? An X-percent drawdown for the day, and it's time to shut off the monitor and take a long walk. This is better than the first idea, but considered in isolation may be nothing more than a band-aid to cover up a deep wound. You may be able to mechanically obey this rule without question, and in doing so temporarily save yourself from your worst self, but from personal experience this method does not hold up on its own; if one is to truly believe in the independence of each trade, why should one ever arbitrarily stop trading if he sees an opportunity ahead? The market has no clue how many losing trades you're coming off of, so what difference does it make if the past is past? How do you reconcile the apparent need for limiting one's trading with the fact that one's losses should have no bearing whatsoever on the next opportunity?

Ultimately, we must ask ourselves this question: what is the line that differentiates sensible risk management and arbitrary, patchwork rule-making? I think the difference comes down to understanding and trusting why certain rules are put into place and how they exist as expressions of positive intentions, rather than viewing them as mere restrictions or boundaries that cannot be crossed. For every preventative rule that we think we need to place over our actions, there exists a correlating positive belief that if we truly embraced without question, would render that preventative rule almost unnecessary. Consider the simple placement of a stop-loss order: if we really believed in the possibility that we could always be wrong in any trade, we could do without the stop and just trust ourselves to exit the trade when the situation dictated. Yet what happens when we truly embrace the idea that "we can always be wrong" is that the stop order ceases to be simply an emergency fail-safe that takes responsibility out of our hands; it actually serves as a short-hand extension of the conviction that any trade can go wrong. Getting back to the problem of blow-up sessions, if you're constantly overtrading in an attempt to reclaim losses, simply restricting the number of trades you can place is just a perfunctory response to the symptoms; the real issue behind the problem is whether or not you are truly convinced that innumberable opportunities for profit will offer themselves tomorrow, the next day, and the day after that. If you embrace this idea, then having a maximum cut-off point for daily losses becomes more than just some handcuff; it's a natural expression of a proper trading attitude that you consistently strive for.

In short, concentrating your energies on the positive beliefs and princples behind your goals will make the job of creating and applying trading rules much easier. The proof of this will come when you suddenly find yourself pre-emptively dealing with the issues before the rules ever need to be enforced.