IN THIS CHAPTER

Formulating profit objectives

Using risk-reward ratios

Seeing that greed is another word for fear

Dealing with drawdowns

Managing positions

I'm sure you've often heard that, in trading, you limit your losses and let your profits run. One fundamental rule of trading sounds like this: If you focus on consistent loss limitation, the profits will come by themselves. This statement is correct, as empirical studies demonstrate. (In Germany, for example, 80 to 90 percent of the surveyed portfolios of private investors show a negative performance because their losses repeatedly get out of hand.) In other words, losses are realized too late, and the profits gained are insufficient to compensate for the losses incurred. Traders tend to take out profits too early.

It isn’t enough to chalk up a 60 to 70 percent average of winning trades if you don’t run up profits and your losses are significantly higher than the profits.

Your average profits and losses depend on the selected position sizes and the market fluctuations. The management of your portfolio risks should consider the answers to these two questions:

• What daily fluctuations are you willing to tolerate?
• Have you adapted your position sizes to reflect market volatility?

Combining good money management skills with good risk management skills helps you keep a firm grip on your overall risk exposure and the total return of your portfolio.

For a solid overview of the important subjects of money and risk management, I highly recommend Lita Epstein and Grayson D Roze's Trading For Dummies, 4th Edition (Wiley).

Some traders confuse large market fluctuations with profit opportunities. They increase their positions with increasing market volatility, hoping for fat profits. That strategy can easily go wrong because portfolio fluctuations tend to increase drastically in such conditions, so you'll be under severe psychological pressure to act — and act quickly. Greed is a bad counselor and sometimes leads to overconfidence.

Risk management with foresight means that you adapt your position sizes to current market fluctuations in order to protect your portfolio. If your trades are too large in relation to your portfolio, the portfolio fluctuations can reach dangerous proportions. Follow a simple rule: If the volatility of the market increases, reduce your stakes. The aim is to control the impact of loss periods on the overall portfolio. What risks are you willing to take? Where is the pain threshold for your portfolio? Your risk tolerance determines your portfolio risk and thus the position sizes you trade with.

Managing Your Opportunities Intelligently

No one would argue that the focus in trading should not be on the consistent use of stop-loss orders for loss limitation. Yet that is merely a necessary — but by no means sufficient — condition for successful trading.

If you want to be profitable in the long term, you need to make bigger winning trades.

As the trading psychologist Brett Steenbarger rightly points out, the problem many traders face comes from how they deal with existing opportunities, not from how they deal with the risk of loss. If you have no clear profit goals in mind, it’s difficult to become profitable.

In Chapter 2, I talk about how process goals are more important than profit goals because designing your trading processes means you have everything under control — though you can never hope to have any real control when it comes to achieving your profit goals. The markets are the only factor that determines things like profits. Don’t draw any wrong conclusions from what I say here, however — establishing frictionless processes certainly takes priority, but this includes establishing a consistent loss limit. At the end of the day, you still want to earn money from your trading. In other words, despite the fact that much is out of your control, you should think very specifically about the profits you want to achieve. Ask yourself the following questions:

• What is your absolute take-profit target for each trade?
• What is the time frame (hourly/daily/weekly) for achieving your profit target?
• How do you define the risk/reward ratio for each of your trades?
• What rate of return do you want to achieve with your trading account weekly, monthly, and/or annually?

Set your focus on achieving realistic profits, and plan these to the letter in advance. Part of your plan should include

• Finding out how high the opportunities and risks are before opening a position
• Playing through all possible scenarios in your mind beforehand
• Knowing exactly what you'll do if you're racking up profits or if the market is against you

Experience shows that most traders pay a lot of attention to finding the right entry point. Perfect timing rarely works in the real world, and it should not be your goal either. Pay attention to managing your trades from entry to exit rather than to finding the perfect sweet spot.

If you find it difficult to take the plunge and enter the market, start with a partial opening. Once you’re in the market, you'll find it easier to actively manage the position and expand it, if necessary. Brain research states that even the smallest activities work to break up mental blockages.

The entry is only the first part of the practical implementation of a trading setup. Stop-loss limits, position size, holding periods, and establishing realistic profit goals are further components. The next section deals with the correct ratio of profit opportunities to loss risks.

Balancing Opportunities and Risks (Risk/Reward Ratio)

The risk/reward ratio (also known as the R/R ratio) is the central control instrument in trading. It’s one of the fundamental principles when it comes to managing money as well as risk. The R/R ratio sets out the potential losses for each individual trade in proportion to the potential gains. In this way, you can measure an investment's potential performance. You get a feel for the risks you’re taking in order to reach a specific profit goal.

Say you purchase a share at the current price of 10 dollars. You secure the position with a stop loss at 9 dollars. Your take-profit limit for closing the position is 12 dollars. Your loss risk is the difference between the purchase price and the stop loss. Your potential profit is the difference between the purchase price and the target price. Then you divide the potential profit by the potential loss. In this simplified case, the R/R ratio is 2:1 (12–10/10–9).

The R/R ratio says nothing about the probability of your trade being successful. Instead, it shows you what profit you can expect when you risk a dollar — assuming that you achieve the profit goal.

Empirical analyses show that you should seek an average R/R ratio of 2:1 per trade in order to be successful in the long term. That sounds obvious because the larger the R/R ratio, the more loss trades you can cope with.

Therefore, an estimated success rate of 50 percent means profitability for you. As sobering as this statement sounds, few traders manage to continuously close more than half their trades with a profit. That’s why controlling profitability with a sufficiently high R/R ratio is important.

However, some traders make it too easy for themselves. You must consider the relationship between your hit rate — the percentage of your positions that have actually reached the profit targets — and your R/R ratio. The higher the R/R ratio, the lower the hit rate. That means if you set an unrealistically high profit goal, the probability of achieving it is comparatively low. With a R/R ratio of 10:1, for example, the question naturally arises of whether it’s possible to ever achieve this profit goal. In short: The larger the R/R ratio, the less likely it is that you'll achieve such ambitious goals.

Never daydream! Price targets should be realistic and not influenced by your pipe dreams or euphoric moods.

Be aware that trading only deals with probabilities determined by the market. You should keep that statement in mind when you’re calculating your profit opportunities. It seems that, for certain traders, the temptation to cheat themselves is just too strong. Errors in reasoning, as illustrated in the following list, sneak in involuntarily:

• Such traders plan a trade and increase their profit target higher until they get a better R/R ratio — even though the probability of reaching that price target is quite low.
• Such traders drag the stop-loss limit closer to the purchase price in order to make the R/R ratio appear more attractive. Here, the danger comes from being stopped out prematurely.
• To compensate for a trading loss, they increase the price target for the next trade. In this case, you’re fighting the market, indulging in what is known as revenge trading. You want to recoup lost money.

In all three cases, you’re ignoring market mechanisms. You’re no longer following the market — you've devoted yourself to the unnecessary manipulation of R/R ratios. Calculating the R/R ratio in a subjective manner is obviously a weakness and a counterproductive use of this particular control mechanism.

The dilemma is simple and poignant. Although a high R/R ratio has a positive impact on expected profitability, it nevertheless leads to a lower probability that your price targets will be achieved.

Your trading style always influences your risk reward ratio. A scalper who trades on very short-term time frames with low position sizes may choose a significantly lower R/R ratio than a swing trader who may keep positions over several days or weeks.

If you have extensively tested and trialed your trading strategy, you will usually be good at predicting what R/R ratio is realistic for your trades. By paying attention to the price movements, you can calculate the required hit rate and a R/R ratio that’s appropriate to the market. This is the way to compensate the advantages of a high R/R ratio with the disadvantages of lower probability.

You need to plan a realistic R/R ratio for every trade you make according to the market environment and what suits your trading strategy. Successful traders are the ones who enter positions with low risk and relatively high profit opportunities.

Resisting the Evolutionary Urge to Cash In

Our evolutionary heritage weighs heavy on us humans. Allowing your profits to run up requires enormous self-discipline because you have to act against your nature. Your trader psyche will always find creative excuses for why you need to quickly close a position that is making a profit. Maybe you tell yourself the following:

• Many pennies make a dollar.
• No one has ever died from taking out their profits.
• Greed is a bad advisor.

From an evolutionary point of view, we humans have a natural reflex to realize profits quickly. Without even thinking about it, your brain will automatically fall back to trusted behavioral mechanisms. This desire for immediate reward (instant gratification, in other words) is controlled by the release of the neural messenger substance dopamine, also colloquially known as the happiness hormone.

Recognizing That Fear Is a Bad Advisor

The list of excuses you can come up with for taking early profits goes on and on, but it shows one thing, above all: A person is mortally afraid of losing the profits they have made — a fear based on the pain they will suffer if they, after making a profit, manage to later lose the unrealized book profits.

The problem is a lack of confidence in your own trades. Your whole attention span is absorbed by the development of this one position. You’re suffering from tunnel vision and can only focus on how much money you could win or lose with this single trade. You involuntarily interpret every price movement as a potential danger or threat. You’re caught up in your emotions and have lost sight of what is happening in the market.

From a psychological point of view, you aren’t really worried about a single trade; rather, it’s your ego that identifies with these concerns. That throws your emotional balance off kilter.

If you feel emotionally off balance, leave the room. Take a deep breath and make sure to use physical movement to relieve the emotional tension. This strategy allows you to bring a planned trade to an end as planned and in accordance with your rules.

Gaining Emotional Distance

I'm asking you to keep in mind these three principles, which will probably help you act objectively and with emotional distance:

• Define a profit goal for each trade beforehand.
• React only to market changes, not to individual positions.
• Concentrate on the profitability of the entire portfolio in any given period, not on individual trades.

As long as you maintain the perspective of a neutral observer, you're in a position to control your subjective concerns about the outcome of individual trades. Clear price targets will help you keep a cool head. Whenever you feel that you’re starting to think about the profits or losses of an individual trade, distance yourself and take a break. Use the break to think about what triggered your loss of concentration or distracted you from what was happening on the market. Ask yourself these questions:

• Was it the fear that you cannot endure individual losses?
• Was it a sense of excitement at the prospect of making possible high profits?
• Was it the fear of later losing your book profits?

The triggers vary depending on the situation and the general mood. In addition, every trader reacts differently, depending on their personality. You must learn to recognize such triggers at an early stage. After you recognize them, ask yourself these questions:

• Are there recurring patterns I can observe?
• How does my ego react to particular triggers?

If you can find the answers to these questions, you'll find it easier to stick with the three principles I mention at the beginning of this section. I admit that it isn’t easy to keep calm when profits increase under significant fluctuations. Experienced traders know that only those who have the most trust in their own strategy can endure the uncertainty about the outcome of a trade. It often seems as though you need more self-confidence in order to stay with a trade that is making profit than with a trade that is running sideways or even at a loss. The reason is obvious: Sometimes, high book profits are at risk!

In Chapter 6, I talk about some mental self-coaching techniques that may help you to remain both calm and confident. I recommend checking out that discussion.

You can spare your nerves by trailing the stop loss to your purchase position or even into the profit region. This enables you to render the position risk-free although such an assurance may bring with it smaller book profits under certain circumstances. Be sure not to place the stop too narrowly and get picked off on the next counter-movement.

Alternatively, you can realize partial profits and let the remaining position continue to run according to plan. This gives you a feeling of freedom of action and reduces your fear of completely losing book profits. At the same time, you find out that it can be worthwhile to allow profit to run up to the target price. In effect, you hit three birds with one stone.

The practice of meditation is an excellent exercise for observing thoughts without judging or identifying with them. Thoughts come and go, but you remain relaxed in the observer role. You'll find that meditation makes it easier to tolerate uncertainty.

Keeping Greed in Check

An old German proverb states unequivocally that "Greed rots the brain!" It’s meant to describe what happens when someone's intellect is overridden, and greed takes over. On the other hand, you have the (fictional) Gordon Gekko's famous dictum "Greed is good!" as expressed in the Hollywood film Wall Street. Which point of view is correct here?

Before answering that question, let's start with a simple definition. Greed describes the excessive desire to want more and more: more possessions, more money, more success, more fame.

So, is greed bad, as the German proverb insists? If you were to answer from a purely biological evolutionary point of view, you would have to say no. After all, without the strong drive to find more food and reproduce, humanity would not have survived. Here are some other benefits of greed:

• Greed helps people overcome obstacles and fears.
• Greed increases the willingness to take risks and provides unexpected powers.
• Greed makes people curious and increases their thirst for knowledge as well as their willingness to learn.

However, times have changed. People are no longer living in the Stone Age. Money and the stock market are products of the modern era. The truth is that the human brain has its origins in a much different time. It wasn’t made for rational investment — and certainly not for short-term trading.

You say money isn't everything? Well, neuroscientific studies show that any monetary gains someone obtains without having to work a 9-to-5 job for it brings with it significantly more happiness hormones than money they might earn from a paycheck. Maybe that’s why traders are prone to emotional outbursts.

Besides fear, greed is one of the two most dangerous emotions in trading. In fact, you can think of greed as just another form of fear — the fear of not getting enough. When combined with an inflated ego, greed and fear can turn trading into a vicious circle. (See Figure 4-1.)

You know how important it is to take advantage of existing profit opportunities. If you're unable to regularly realize greater profits, you'll never be a profitable trader, for the simple reason that you'll suffer frequent losses, no matter what you do. Even the best traders out there rarely have more than 60 percent winning trades.

The natural and deep-seated reflex to quickly take out profits is difficult to control. That’s why clearly defined profit targets for each trade and emotional distance are important.

So, how and when does greed come into play? How about "with overwhelming force" and "all the time"? (That’s certainly more than you want when trading.) As for the consequences of greed, this list gives you some answers:

• Greed drives you to continue what you’re doing even if you have suffered a losing streak.
• Greed drives you back to the market after a crash.
• Greed can sometimes make you forget your rules and take disproportionately large risks (over-leveraging, in other words).
• Greed makes you resort to gambling and risky speculation.
• Greed leads to overconfidence and loss of control.
• Greed leads to overtrading or revenge trading.
• Greed keeps you from learning from your errors.
• Greed is responsible for market excesses and speculative bubbles.

Neuroscientific studies confirm that greed rots your brain, by effectively switching it off. At the same time, some part of your brain must still be available to you in order for greed to function. This offender sits in the emotional centers of the brain, functioning as the core of the limbic reward system. It is the nucleus accumbens, which, when over-activated, ramps down access to your intellect. When the nucleus accumbens comes into play, you don't stand a chance.

The nucleus accumbens (NAc) plays a central role in the limbic reward system and is responsible for the development of addiction. Dopamine receptors in the NAc respond immediately when dopamine — the happiness messenger — is dumped into the system. The NAc looks to repeat that pleasurable release, reinforcing the already strong human desire for reward and pleasure. Sexual desire, gambling addiction, drug addiction, and mobile phone addiction are controlled by dopamine. The dopamine output sends a signal to the body and the mind, demanding that the desire be satisfied.

Greed triggers motivation to move toward something. The deep-seated desire for profit is superimposed on your fear of loss. The determining factor is the prospect of profits — the expectation of profitable trades, not the actual profit. It is this expectation of a reward that triggers neural fireworks in your brain and releases dopamine. This expectation anticipates the profits and reacts physically and mentally as though the profits have already occurred. That may tempt you into ignoring the risks and your own rules. You react according to the motto “Anticipation is half the fun” and enjoy the dopamine hit.

Following the rules when trading is boring for your brain. Subliminally, you’re looking for the risk and the adrenaline rush. Dopamine is addictive. The brain is hungry for reward. The human reacts to expected profits as it does to drugs or sex. The neural and biochemical processes in the brain are identical when it comes to any of these desires.

When the profit actually occurs, your dopamine output returns to normal and the rational parts of the brain are reactivated. Disillusionment returns. As soon as a trade enters the profit region, the fear of loss takes over. This fear encourages risk-averse traders to realize smaller profits rather than let them grow. It is a to-and-fro action between greed and fear.

Imagine that you have realized a few smaller winning trades. You think this must be your lucky day — it’s happening. This may be when you get cocky. Your happiness about the profits you've made is buried under the prospect of further, higher profits. Your NAc is activated, and the release of dopamine leads to an increased willingness to take risks. You increase the size of your positions and leave out the stop-loss limits for now. After all, you expect a winning trade. The prospect of additional wins makes you forget all the rules. The stronger your expectation of a reward, the stronger the activity in the NAc. Your intellect is powerless against these forces. And afterward you have no idea how it happened. How could you have lost control? It's quite simple: Your thinking apparatus was in a waking coma.

When your neural mechanisms kick into gear, it’s nearly impossible to stop them. You must react at an early stage because, frankly, you don't have much time. That’s why prevention is important: It’s critical to have trained processes and a fixed set of rules in place when trading. You need iron discipline and mental strength so that you don’t fall victim to greed. Above all, keep the following guidelines in mind:

• Keep your distance by adopting an observer role.
• Never take the losses personally.
• Never identify with your trades (non-attachment).
• Take a break and move your body when you have the feeling of becoming cocky or euphoric.

For an overview of mental self-coaching techniques that might help you in managing your neural mechanisms, see Chapters 6 and 7.

Greed that is difficult to control in trading leads to a lack of discipline and points to addictive behavior. Psychological studies indicate that there may be deficits in personality development. The German Central Bank and the European Securities and Markets Authority (ESMA) regularly warn against the consequences of excessive speculation with leveraged products. The large number of individuals who are essentially addicted to playing the stock market is a cause for concern.

Managing Losses: The Trader Psyche at Its Limit

I return time and time again in this book to the depressing topic of trading losses. After all, it's not easy to have an occupation where losses are a normal part of everyday life. In any other job, you receive a fixed salary for the work you've done, and you may even earn a performance bonus. Imagine a situation where, if your performance were poor, you would not only forfeit your paycheck but also have to hand over money to your boss. Unthinkable! But this is how it works on the stock exchange. It’s not simply the case that you earn nothing if your strategies and setups don’t work out. What's worse is that you have to come to terms with the fact that, despite all the hard work you may have done, you still have to pay out on top of that and lose money.

This unfortunate series of events occurs in half of all trades, according to statistics. That not only hurts a great deal but also runs contrary to our evolutionary development. Human nature was not created for trading. Impending loss inevitably triggers ancient programs in your brain. If you were to follow your natural instincts in trading, your portfolio would probably be ruined in the shortest possible time.

If you don’t want to belong to the vast majority of private traders who, according to statistics, fail on the markets in either the long term or the short term, you need to learn to deal proactively with losses. More specifically, you need to build up your defenses against your own evolutionary heritage — an emotional bulwark, as it were. The building blocks for such a bulwark consist of frictionless trading processes and explicit rules — not particularly exciting, I admit, but it’s the only way to get a grip on your emotions, your ego, and your deep-rooted response patterns.