Have you ever wondered why professional traders seem to talk more about boring things like risk management, position sizing, and diversification rather than the latest profitable trading strategies? As a new trader, I always struggled to understand this. After all, it’s the trading strategy that makes us money, right?
While technically true, thinking that just finding a profitable trading strategy will make you rich is about as wrong as it gets. Without proper risk management, you stand the chance of getting wiped out after just a few trades no matter how good your strategy is. And the sad thing about trading is that once your trading account gets wiped out, there is normally no second chance. There is simply no more money to trade with!
Therefore, as you become a more advanced trader, it is likely that you too will spend most of your time researching and optimizing your risk management technique rather than looking for new trading strategies online.
Learning from the professionals
The first thing we should address when it comes to risk management is the issue of leverage. While leverage is indeed a fantastic opportunity for retail traders without a lot of capital to be able to boost their profit potential, it also comes with plenty of risks.
Like most good things in this world, leverage should be used with caution. As you start out with trading, don’t worry about maximizing your short-term gains. Instead, keep in mind that you are in it for the long-term. Focus on the process, not on the dollar amount you are making (or losing) on each and every trade. This is how all professionals approach trading. If you wish to become one, you should do the same.
Another thing professional traders seem to obsess about is diversification. For example, mutual fund managers do this by spreading their investments across companies in different sectors of the economy. Hedge fund managers do it by investing in a variety of non-correlated assets. As forex traders, however, we need to take a different approach to this.
One way to diversify our risk is to spread the risk on a larger number of small trades rather than a few big ones. This is actually one of the most effective ways of making the “law of large numbers” work in your favor.
You see, no matter how good your trading strategy is, you still never know how the next trade is going to play out. Small samples are statistically insignificant. However, given a large enough sample size, probabilities will play out the way you expect them to.
When we talk about risk management, we also need to touch on what may be the biggest obstacle of them all; our own mentality and ego. As you may already know, humans have an inherent desire not to be wrong, which is why many traders have a bigger problem fighting their own mind than they have fighting the market.
Obviously, it would be great if we could be right all the time, but this should not be the goal and you should not put your ego into being right. If you do, it will become a major obstacle to risk management, and you will have an extremely difficult time with even easy things like abiding by your own stop-loss.
Therefore, taking your emotions out of trading is crucial to properly deal with risk management. If you can just manage to follow the strategy without letting your mind getting in the way of your risk management, you don’t need to worry about the profits. Over a large enough number of trades, the law of large numbers will take care of that for us.