By: Chris Irvin, Veteran Instructor & Trader at The Wizard
I have been married for 22 years, and in that time I have adopted these words as my words to live by – “You can be Right or you can be Happy.” This motto, with a slight tweak, can also go a long way in helping me with my stock market relationship.
The starting point for a meaningful relationship with the market is this: “The market is always right!” The market may not always make sense, but it is always right. The problem with many struggling traders is that they have not figured this out. If you are a trader who believed that you always have to be right, you are probably going through some difficult times. There have been several times in my own trading that following a few successful trades the word “genius” starts to creep into my internal vocabulary. This is a very bad sign. When I start to think I can’t make a bad trade, the reality is I should probably sell every position I have because I am about to be humbled.
The key to trading is not learning how to be “Right and Happy,” It is about learning how to be “Wrong and Happy.” The trader who feels that they always have to be right will more than likely never trade with any type of money management. If you are a person who only considers how much money you can make in a trade without considering the risk in the trade, you will never be successful. Why? John Maynard Keynes said it best when he said “The markets can stay wrong longer than you can stay solvent.” You remember the feeling. You are in a trade and it begins to go against you. You puff up your chest and think “it will come back – I know I am right,’ only to have the trade get you so far upside down that you cannot afford to exit the position. Just think what it would have been like to have nipped that loss in the bud as the position began to fade rather than waiting for it to crush you.
It seems strange, but the most successful traders are the ones who know they are going to be wrong at some point. Knowing this to be the case, these traders always determine the worst case scenario before hitting the “trade” button. These traders will only make the trade if they are comfortable with the worst case scenario. If you are willing to put your entire account balance into a trade without a stop loss, you should be comfortable losing it all. If you are only willing to lose $100.00 in a trade, then you should construct the position so the most you can lose is $100.00. How might you do this? Start by becoming aware of the two different types of risk. The first is trade risk, and the second is account risk.
Trade risk is the amount of risk in the position itself. The easy way to think about this that it is the difference between entry point and stop loss. Let say a stock is trading for $42.20 and the most recent swing low is at $42.00. This means that there is .20 cents worth of trade risk in the position if I put my stop under the swing low.
Account risk is the amount of money you have determined you are willing to lose in any one position. This number should be part of your trading plan. Let’s say that for our example, the most we are willing to lose in any one trade would be $100.00. Trade risk and account risk come together through position size. .20 cents worth of trade risk divided into $100.00 of account risk would tell you to purchase no more than 500 shares of the stock. This way you know that if your stop loss is hit, you can’t lose more than $100.00. Here is the equation:
Acceptable Account Risk / Trade Risk = Positions Size
Now we all know that there are gaps and other unusual circumstances that can take even the most defensive trader to the cleaners. But over the long haul, a trader that is comfortable with being wrong and happy will likely be more successful than the one who has a need to be right and happy.