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Risk
and Success
By Brett N. Steenbarger, Ph.D.
Sometimes you hear people debate whether trading
success is attributable more to trading techniques vs. psychology.
The answer, of course, is both—but the point where the two intersect
is risk management. A huge percentage of trading success or failure
can be laid at the doorstep of risk management. A recent book on
risk management observed that,
across different traders and trading firms, 90% of all profits were
attributable to 10% of all trades. While traders would like to
think of themselves as making money on a majority of their trades,
the reality for frequent traders is that a minority of trades are
winners—and it is the few large winners that produce a favorable
profit/loss statement (P/L).
The book goes on to observe that, if 10% of
trades account for a majority of profits, it follows that a large
percentage of trades have to be “scratched”. A cardinal skill in
trading is recognizing that a trade is wrong before it hurts the
P/L. Time and again, I have seen good traders exit trades when the
trades fail to move in their direction; bad traders exit only after
the trade has moved against them.
And yet it is equally true that, if 10% of trades
are going to account for the lion’s share of profits, traders must
be willing to milk very good trades. This not only means finding
the sweet spot where you can “cut your losses and let your profits
run”; it also means being willing to trade sufficient size to
maximize returns from a good trade. The worst traders I know put on
their maximum size when they’re trading at their worst. Typically,
they have just lost on one or more trades and now are trying to get
the money back. The best traders are able to identify superior
trading opportunities—and are patient in waiting for those—and will
put size on to take advantage of these. This is how 10 good trades
more than make up for 90 scratches and losers.
A favorite trading story that I tell concerns a
very successful trader. He promised to tell me the secret of
trading success. Of course, my curiosity was piqued and I asked,
“What is that?” He responded with a question: “What the ratio of
your largest position size to your normal size?” “Three-to-one”, I
told him. He smiled. “Consider 20-to-1,” was his advice and his
success formula.
I completely believed him. The reason he was
successful had nothing to do with finding a better oscillator,
regression analysis, or chart formation. He was successful because
he had the ability to identify—and wait for—particularly profitable
opportunities and then take maximum advantage of those. While 20:1
position sizing is—and will always be—rich for my blood, I think the
principle is valid: success is partly a function of putting size on
for the logical, not psychological, reasons.
This is one reason trading is so difficult. It
is an unusual blending of traits that allows someone to be prudent
with risk, scratching trades that don’t move promptly as expected,
while at the same time milking opportunity. It is easy to find
traders who are risk-averse and stick with their one and five lot
positions; it is also easy to find traders who will swing size
freely, including times when they are frustrated with the trade.
What is rare is to find the mix: the ability to accept and limit the
90% of occasions that don’t work, and yet act aggressively on those
10% of times when there is a move to be exploited.
What is true for size is also true for time.
Much can be learned simply by identifying how long a trader has held
onto winning vs. losing trades. If a trader is quickly exiting
trades that aren’t going in the desired direction, the average
holding times for such trades should be quite low. Conversely, with
the good traders, it’s not unusual to see a trading log that
registers 10% of trades that are held for a lengthy period of time.
Invariably, these are the winners that contribute significantly to
the overall P/L. The truly unsuccessful traders will also display a
minority of trades with long holding times—and these will be the
losers. I recently asked a trader why he hung onto a long position
for an unusually long period of time. He looked at me somewhat
quizzically and replied, “Because I had the bottom!” He was willing
to sit through a choppy trade as long as it went in his direction
and as long as nothing happened to convince him that he didn’t
identify the bottom. That one trade made his entire day.
Perhaps this is a truism in all of life. The
people who I have seen who have been very successful in dating and
relationships have been willing to go on very many first dates, but
not so many second and third ones. They “scratch” the unpromising
dates and then focus their energies on the 10% that look
worthwhile. The same is often true with respect to career and
company success. A successful individual may take on ten projects
over the course of a year, but focus efforts on a single initiative
when it yields promise. A company may roll out ten products and
quickly pull nine, making significant money on the one that finds
ready acceptance in the marketplace. Even successful artists and
inventors, researcher Dean Keith Simonton found, tend to churn out
creative efforts, deriving their fame from the small minority of
works that attract the attention of an appreciative world.
Successful traders risk manage their market
exposure. Successful individuals risk manage their life exposures.
It is not just how much we undertake, but how much we scratch in
life that determines our ability to benefit from the episodes of
promise that come our way.
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Brett N. Steenbarger, Ph.D. is a clinical
psychologist and active trader, writer, and
researcher for the past 20 years, Brett is the
author of The Psychology of Trading (Wiley;
2003) and numerous articles on trading psychology
for print and online financial publications.
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