Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

PRICE RISK MANAGEMENT ISSUES: AN OVERVIEW

Although price risk management will not turn a losing trading strategy into a winner, it is arguably the most important topic in this book because it can prevent the failure of an overall profitable trading system. Imagine a system that produces an astonishing 90 percent win/loss ratio, and pair this system with a trader who commits all accumulated profits—along with the original stake—to the next trade. According to the laws of probability, on average, such a trader would end up broke by the termination of the tenth position.

The other reason why I believe price risk management is such an important tool in the trader's arsenal is that we can never control the markets, only how much risk we will assume in them. Because we can never know with certainty whether any particular trade will result in a profit or a loss, it is the height of folly to focus our attention and capital on those aspects of trading over which we have no control while simultaneously neglecting price risk management, the one essential aspect of trading over which we exercise absolute control.

Of course, we do also have control over which entry point we choose for any particular trade. However, the selection of precise entry levels probably represents the least significant aspect of a successful trading system. In his book, Trade Your Way to Financial Freedom, Van Tharp illustrates the lack of importance of precise price entry levels chosen in the development of a successful ...