Writing prompts: Trading psychology and risk management

111713_1458_RiskManagem1.jpgContinuing from my last post, here are the rest of the questions my friend asked me to expound upon.

What is Risk Management and should it be lumped together under Trade Management or separated?

Risk management is one of the great buzzwords of our time. Who wouldn’t want to manage risk? If someone is trading or managing your money, aren’t you glad to know they are thinking about risk? So often, it’s just an empty buzzword.

However, it’s also one of the most important pieces of the puzzle. Trading is about taking on the right risks at the right time and doing the right thing with those risks (managing them appropriately.) I want risk—as a trader I know risk is basically the fuel that makes the trading engine go. I could draw a schematic diagram that shows my trading methodology takes risk in and converts it to profit; that’s one way to think about the essence of trading. However, too much risk, the wrong kind of risk, risk at the wrong time—these can and do kill.

Risk is a powerful force, and it is also one of those things that hovers at the edge of what is knowable. When we really start to think about the edges of what we know, the math becomes a little thin, too. Can the average trader safely ignore such musings? I think the hobbiest can (and there’s nothing wrong with that… no judgement at all. Remember the root of the word “amateur” is essentially someone who loves something. There’s nothing wrong with someone being an amateur trader as long as they understand it’s not a get rich quick scheme), maybe at least for a while. But I also think anyone trading any significant risk needs to spend some time thinking deeply about this issue because there will be a day of reckoning.

Risk management is often used to simply mean trade management. That’s one of the problem with trading lingo: the use of language is very imprecise and there’s no accepted lexicon. Not only do you have to work to understand what a writer is saying, sometimes you have to work to understand even the basic meanings of words and terms because he’s using them in new ways. I think of risk management and trade management as two separate things.

I started this section with some cerebral and probably not terribly relevant thoughts about risk, but there’s also the everyday risk management, which means I’m taking size on each trade that is not likely to blow me up, I’m taking trades in liquid markets that I can probably get out of if I need to, and other issues like that. Risk management is basically part of the framework that lets us apply our trading edge without bad things happening to us.

Trade management, to me, is more of a set of things we can or cannot do while in a trade. As a buzzword I guess it could be lumped together, but it doesn’t truly make sense. Trade management is just what you do while you’re in a trade; it may be a significant part of your edge, but it’s not, strictly speaking, risk management, any more than your entry technique is risk management. (Yes, yes, those of you who like to argue semantics will soon remind me that I just said all trading is basically risk management, so…. yeah, I know.)

What is trading psychology?

Both the most important topic and, in the hands of many, complete BS. The problem comes when people think trading psychology is an edge—it is not, in itself an edge. I’ve written on this before, but the idea that all that matters is you believe something and trade it is silly. This doesn’t work in other disciplines. What if the heart surgeon believed, deeply, that he should pack duck feathers around heart after surgery? What if the ship captain believed that the best course of action in high seas was to turn his ship abeam to the incoming waves? How would that work out? Their beliefs, no matter how powerfully held and repeatedly set out on vision boards, would run afoul of the rules of nature. It’s the same for traders.

There are forces in the market (but they are well hidden in the random noise of the market.) Our beliefs must be correct beliefs—they must be aligned with the way the market really moves. This is the missing piece of much trading psychology, and I fault many of the vendors who want to sell books and courses on trading psychology. If you were going to build a business centered around psychology, an effective strategy would be to trivialize the problem of actually finding an edge—perhaps you’d just tell people they could have any old belief because it was easy to create a system for the market—and then had to work on your psychology (with extensive courses, seminars, and sessions) to be able to apply that belief. If it doesn’t work, it’s your fault because your psychology is not correctly aligned so you better work on that more.

Am I being cynical? You bet. But this is only half of the point. I also said trading psychology is also the most important topic. It’s absolutely possible a trader knows what to do and can’t do it. I’ve seen bizarre things happen, like the hand make a trade without the mind being aware—the power of the mind to sabotage traders is awesome. No matter what richness we have in our inner landscape, none of that matters–all your intentions, past experiences, or positive visualization don’t matter if you can’t push the button to get in and out of the market at the right time. Actions are all that matter in trading; all that matters is what you do.

In that sense, trading psychology serves and supports your edge. Without the proper framework, you can have the best edge in the world and be unable to apply it if you do not believe in it. I’ve written on this before, but taking care of yourself and your mental space truly is a critical part of the trading process and discipline. For many traders, doing some deep work to uncover stumbling blocks and limiting beliefs can be beneficial, but I’ve also seen many cases where simply aligning actions with the market can correct many psychological issues. If you’re trading without an edge, you should feel bad about that! You should have some psychological angst until you get your beliefs and your methodology aligned with the way the market moves.

What is homework and is this even the right word?

First off, I don’t think it’s the right word. Homework, to me, has a Puritanical connotation and practically guarantees misery. This is not how we should think about our trading work. To me, the discipline of trading must be encapsulated in a complete process. Here are some important areas, but I don’t pretend this is the complete list:

What you actually do to get in and out of trades and monitoring open trades. For me, this means I always know what I have on, what’s likely to come off and how, and what’s likely to trigger new positions in the future. Reviewing a full screen of limits and stop limit orders once or twice a day is not fun, nor is updating P&L and risk sheets, but this must be done. It’s just that simple–if you can’t do the basic stuff your trading methodology demands, then you cannot be a trader. Period.

What I started to learn to trade, I thought the short paragraph above was “trading” and that “being a trader” meant doing that. I was wrong; there’s a lot more:

What I need to do to find new trades. This covers a wide range, but it means that I rather intimately know a few tens of markets, actively monitor about a hundred on a minute by minute basis (and sometimes am aware of what’s happening at 3 am when it matters), and look at several hundred more each day at least once. You may have a very different system, but you have to do that work.

What I need to do to research and understand my edge. I’m always doing research and reading new things and ideas. I’m constantly finding new growing edges for myself to explore. I want to know everything I can about the markets I trade, and I try to have contact with people who challenge me and make me smarter.

What I need to do to take care of myself. This covers physical things like diet and exercise. (I suppose I should put get enough sleep on any reasonable list, but I don’t pretend to do that…) It also covers mental and spiritual aspects, which are probably just as important. Simple things matter: pet a fluffy cat, go for a walk in the setting sun, talk to a friend, but I also find that I need to indulge my hunger to master other disciplines. I enjoy cooking–some nights I will sharpen my knives freehand on Japanese waterstones… even this simple discipline hides years of practice and experience in honing the edge. I’ll bake bread, but I’ll strive to bake picture-book perfect levain breads that would not be out of place in a basket in a Parisian bakery. I’ll work on a piano piece, but I’ll spend hours over the course of a week working on a fine alignment of hand and wrist and relaxed shoulder. I’m leaning to be a photographer, and that involves study of space, light, object and ground, color, proportion… you get the idea. Pouring myself into these disciplines, and striving for perfection, makes me better and that makes me a better trader.

Before enlightenment, chop wood; carry water. After enlightenment, chop wood, carry water.


Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.

This Post Has 2 Comments

  1. DB

    ‘Before enlightenment, chop wood; carry water. After enlightenment, chop wood, carry water.’ This is one of the most profound teaching i learned recently. Simple to understand but difficult to attain that state.

  2. Les Meehan

    Hi Adam
    Another interesting and revealing post!
    I agree that there is a lot of BS in trading psychology (and in the rest of the trading industry) especially in the marketing of stuff.
    I do think you hit it right when you say it is important to have the right beliefs to support trading and I believe the wrong beliefs can kill an account faster than that heart surgeon and the feathers!
    I also believe aligning beliefs for trading success is a powerful part of a trader’s mindset development.
    Thanks for all you do in your sharing of good advice/ideas…
    Kindest regards

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