The U.S.

boxer Mike Tyson, quoted by The Economist:

“Everyone has a plan ’til they get punched in the mouth.”
This is why risk control must be an essential part of every trading system.

The inability to manage losses is one of the worst pitfalls in trading.

Beginners freeze like deer in the headlights when a deepening loss starts wiping out profits of many good trades.
It’s a general human tendency to take profits quickly but wait for losing trades to come back to even.

Professional traders quote that “successful trading should be a little bit boring.” They spent
long hours each day doing homework, sifting through market data, calculating risks, and
maintaining records. Those time-consuming tasks aren’t exciting—but their success is built
on such grunt work. Beginners and gamblers get a full load of entertainment, but pay for it
with losses.

Professional traders don’t count money in open trades. They do it at the end of an accounting period,
such as a month. Never get in the habit of counting Rupee in open trades, count the ticks/points but
not rupee. Do it only at the end of the trade.

Another key point: a professional doesn’t get worked up about his wins or losses in a single trade.
Handle each trade like a surgical procedure—seriously, soberly, without sloppiness or shortcuts.
Concentrate on trading right. When you work this way, money will come later.

Dreaming in the markets is a luxury we can’t afford. Dr. Shapiro describes a test that shows how
people conduct business involving a chance. First, a group of people are given a choice: a 75 percent
chance to win $1000 with a 25 percent chance of getting nothing—or a sure $700. Four out of five
subjects take the second choice, even after it is explained to them that the first choice leads to a $750
gain over time. The majority makes the emotional decision and settles for a smaller gain.

Another test is given: People have to choose between a sure loss of $700 or a 75 percent chance of
losing $1000 and a 25 percent chance of losing nothing. Three out of four take the second choice,
condemning themselves to lose $50 more than they have to. In trying to avoid risk, they maximize
losses!

Emotional trading destroys losers. A review of trading records usually shows that the worst damage
was done by a few large losses or a long string of losses, while trying to trade one’s way out of a hole.
The discipline of good money management would have kept us out of that hole in the first place.

An edge lets you win more often than lose over a period of time. Without an edge, you might as well
give money to charity. In trading, the edge comes from systems that deliver greater profits than losses,
after slippage and commissions, over a period of time.

The best trading systems are simple and robust. They have very few elements. The more complex the
systems, the higher the risk that some of its components will break.

Finally, once you develop a good system, stop messing with it. If you like to tinker, design another
system. Most traders take a good system and destroy it by trying to make it into a perfect system.

Once you have a trading system that works, it’s time to set the rules for money management. You can
win only if you have a positive mathematical expectation from a sensible trading system. Money
management will help you exploit a good system, but cannot rescue a bad one.
The Two Main Rules of Risk Control
If trading is a high-wire act, then safety demands stringing a net underneath that wire. If we slip, the
net will save us from getting smashed against the floor. The only thing better than a safety net is two
safety nets: if one doesn’t catch us as we fall, the other will.

The two pillars of money management are the 2% and 6% Rules. The 2% Rule will save your account
from shark bites and the 6% Rule from piranhas.

Ugly losses stick out like sore thumbs from most account records. Every performance review shows
that a single terrible loss or a short string of bad losses did most of the damage to an account. Had a
trader cut his losses sooner, his bottom line would have been much higher. Traders dream of profits
but freeze when a losing trade hits them. If you follow risk management rules, you’ll quickly get out
of harm’s way instead of waiting and praying for the market to turn.

The three worst Mistakes

1) Not putting stops
2) Put on trade that are too large for account size
3) Overtrading
The 2% Rule prohibits you from risking more than 2% of your account
equity on any single trade.

For example, if you have $50,000 in your account, the 2% Rule limits your maximum risk on any
trade to $1,000. This is not the size of your trade—it’s the amount you put at risk, based on the
distance from your entry to your stop.

Let’s say you decide to buy a stock for $40 and put a stop at $38, just below support. This means
you’ll be risking $2 per share. Dividing your total permitted risk of $1,000 by your $2 risk per share
tells you that you may trade no more than 500 shares. You are perfectly welcome to trade fewer
shares—you don’t have to go the max every time. If you feel very bullish about that stock and want to
trade the maximum permitted size, that number of shares will be limited to 500.

A professional trader expects to be profitable by the end of the month or the quarter, but ask him
whether he’ll make money on his next trade and he’ll honestly say he doesn’t know. That’s why he
uses stops: to prevent negative trades from damaging his account.

Technical analysis can help you decide where to place a stop, which will limit your loss per share.
Money management rules will help you protect your account as a whole.

If you have separate trading accounts for stocks, futures, and options, apply the 2% Rule to each
account separately.

Professional traders, on the other hand, often say that 2% is too high and they try to risk le 1% or less
per trade.

How many shares will you buy or sell short in your next trade?

y’ve made money in their latest trade or less if they’ve lost money. In fact, trade size should be based
on a formula instead of vague gut feel. Use the 2% Rule to make rational decisions on the maximum
number of shares you may buy or sell short in any trade. I named this process “The Iron Triangle of
risk control”

See figure below :

You can succeed in futures only with sensible risk control, using the 2% Rule.

A. Calculate 2% of your account value—this will be the maximum acceptable risk level for any trade.
If you have $50,000 in your futures account, the most you can risk is $1,000.

B. Examine the charts of the market that interests you and write down your planned entry, target, and
stop. Remember: a trade without these three numbers is not a trade but a gamble. Express the value of
the move from your entry to your stop in dollars. C.

Divide A by B, and if the result turns out to be less than one, no trade is permitted—it means you
cannot afford to trade even one contract.
Most of us, when we find ourselves in trouble, start pushing harder. Losing traders often take on
bigger positions, trying to trade their way out of a hole. A better response to a losing streak is to step
aside and take time off to think. The 6% Rule sets a limit on the maximum monthly drawdown in any
account. If you reach it, you stop trading for the rest of the month. The 6% Rule forces you to get out
of the water before piranhas get you.

The 6% Rule prohibits you from opening any new trades for the rest of
the month when the sum of your losses for the current month and the
risks in open trades reach 6% of your account equity.

The 6% Rule allows you to increase your trading size when you’re on a winning streak but makes you
stop trading early in a losing streak. When markets move in your favor, you can move your stops to
breakeven and have more available risk for new trades. On the other hand, if your positions start
going against you and hitting stops, you’ll quickly stop trading and save the bulk of your account for a
fresh start next month.
Write down your entry level, profit target, and stop for every planned trade in order to compare your
risk and reward. Your potential reward should be at least twice as big as your risk. It seldom pays to
risk a dollar to make a dollar—you might as well bet on color at a roulette table. Having a realistic
profit target and a firm stop will help you make a go/no-go decision for any trade.

Moving averages and channels help set profit targets for swing trades. They also work for day-trades;
only there you need to pay more attention to oscillators and exit at the first sign of a divergence
against your trade. Profit targets in position trading are usually set at previous support and resistance
levels.

The three targets mentioned above—moving averages, channels, and support/ resistance levels—are
fairly modest. They don’t have you shooting for the moon, but are realistic. Keep in mind that
“enough” is a power word—in life as well as trading. It puts you in control, and by getting “enough”
in one trade after another, you’ll achieve excellent results over time.

How to define “enough”? I believe that moving averages and envelopes, along with recent support
and resistance levels can show us what would be “enough” for any given trade. Let me illustrate this
with several examples: one a swing trade, another a day-trade, and the third a long-term investment.

Stops are a must for long-term survival and success, but most of us feel a great emotional reluctance
to use them. The market reinforces our bad habits by training us not to use stops.

Put a stop too close and it’ll get whacked by some meaningless intraday swing. Put it too far, and
you’ll have very skimpy protection.

It pays to place your stops at non-obvious levels—either closer to the market or deeper below an
obvious low. A closer stop will cut your dollar risk but increase the risk of a whipsaw. A deeper stop
will help you sidestep some false breakouts, but if it gets hit you’ll lose more.

Take your pick. For short-term swing trading, it generally pays to place your stops tighter, while for
long-term position trades, you’d be better off with wider stops. Remember “the Iron Triangle of risk
control”—a wider stop demands a smaller trade size.

One method I like is Nic’s stop, named after my Australian friend Nic Grove. He invented this
method of placing a stop not near the lowest low, but at the second lowest (more shallow) low. The
logic is simple—if the market is sliding to its second lowest low, it is almost certain to continue
falling and hit the key low, where the bulk of stops cluster. Using Nic’s stop, I get out with a smaller
loss and lower slippage than would occur when the markets drop to more visible lows. The same logic
works when shorting—place your Nic’s stop not “a tick above the highest high” but at the level of the
second highest high.
Another method, popularized by Kerry Lovvorn, is to use Average True Range
(ATR) stops When you enter during a price bar, place your stop at least one ATR away from the
extreme of that bar. A two ATR stop is even safer. You can use it as a trailing stop, moving it at every
bar. The principle is the same—place your stop outside the zone of market noise.

One of the advantages of using trailing stops is that they gradually reduce the amount of money at
risk. Earlier we discussed the concept of “available risk. As a trade followed by a trailing stop moves
in your favor, it gradually frees up available risk, allowing you to make new trades.

Don’t Let a Winning Trade Turn into a Loss

Never let an open trade that shows a decent paper profit turn into a loss! Before you put on a trade,
start planning at what level you’ll begin protecting your profits. For example, if your profit target for
that trade is about $1,000, you may decide that a profit of $300 will need to be protected. Once your
open profit rises to $300, you’ll move your protective stop to a breakeven level. I call that move
“cuffing the trade.”

Soon after moving your stop to breakeven, you’ll need to focus on protecting a portion of your
growing paper profit. Decide in advance what percentage you’ll protect. For example, you may decide
that once the breakeven stop is in place, you’ll protect a third of your open profit. If the open profit on
the trade described above rises to $600, you’ll move up your stop, so that the $200 profit is protected.

These levels aren’t set in stone. You may choose different percentages, depending on your level of
confidence in a trade and risk tolerance. As a trade moves in your favor, your remaining potential gain
begins to shrink, while your risk—the distance to the stop—keeps increasing. To trade is to manage
risk. As the reward-to-risk ratio for your winning trades slowly deteriorates, you need to begin
reducing your risk. Protecting a portion of your paper profits will keep your reward-to-risk ratio on a
more even keel.

Move Your Stop Only in the Direction of Your Trade

You buy a stock and, being a disciplined trader, put a stop underneath. That stock rises, generating
nice paper profits, but then it stalls. Next, it sinks a little, then a bit more, and then goes negative,
inching towards your stop. As you study the chart, its bottom formation looks good, with a bullish
divergence capable of supporting a strong rally. What will you do next?

First of all, learn from your mistake of not having moved up your stop. That stop should have been
raised to breakeven a while ago. Failing that, your options have narrowed: take a small loss right away
and be ready to reposition later—or continue to hold. Trouble is you feel tempted to go for the third
and utterly unplanned choice— to lower your stop, giving your losing trade “more room.”

Don’t do it!

Giving a trade “more room” is wishful thinking, pure and simple.

It doesn’t belong in the toolkit of a serious trader.