Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

PSYCHOLOGY OF PRICE RISK MANAGEMENT

Because the amount of risk that we are willing to assume is the only essential aspect of trading over which we exercise complete control, we can never be too diligent regarding price risk management. Why do successful hedge fund managers consistently show average annualized returns of between 5 and 25 percent? Obviously they could show average annualized returns of 50 to 250 percent, but this would greatly enhance their likelihood of ruin. One of the most common reasons retail and institutional traders fail is their lack of adherence to comprehensive, systematized price risk methodologies. This lack of adherence invariably manifests itself through their overleveraging of equity under management.

Although other factors may lead to our inability to “pull the trigger” on a trade, one of the most prevalent and sensible reasons is that we are risking too high a percentage of our total equity on a per-position basis. We should be hesitant to execute a trade if such an action could lead to the end of our careers as traders. This is simple self-preservation. If, prior to execution of a trade, traders are overwhelmed with anxiety, they should ask themselves if suffering a loss on this anticipated position would impede their financial ability to trade in the future. If the answer is yes, they should trade small enough to ensure that this would not be the case.

Our culture thrives on immediate gratification. Microwave ovens, airplanes, fad diets, T1 lines, ...