There are a number of risk management mistakes that traders make, but a personal “risk spike” is one of the hardest to control. It can happen any time, to new or experienced traders, can undo years worth of work in an instant and strikes when the trader is most vulnerable. The term “risk spike” has nothing to do with volatility spikes or sharp movements in the markets. This risk management mistake is personal, and involves a complete, often momentary, lapse in discipline which can have dire consequences.
Risk Management Mistake: Risk Spikes
Here’s a simple example of a risk spike: you win slowly (or lose slowly if starting out), trading by your rules and risking a small amount of capital, but then all of sudden you get sick of the slow capital growth. You see a “great” trade and you view it as your opportunity to really ramp up profits in your account. Instead of taking your usual position which puts 1% of your capital at risk, you load up, taking a position six times normal, effectively risking 6% of your account. We’ll revisit this scenario in a little bit…because it can get even worse.
You know you shouldn’t do it, and that you should be following your trading plan, but you just snap and do it instantly before even having a chance to really think about it. Now you have a very big trade out there. You may also be telling yourself that you’re only going to do this once, and then no more. Unfortunately, when you do it even once–and especially if you win–it becomes harder to resist the temptation to do it next time. Even if you tell yourself you won’t do it again, risk spikes are like an addiction. You can’t ever engage them, because if you do it’s a very slippery slope where you start to have them more and more. The impulse that created the risk spike hasn’t gone away just because you say you’ll only do it once. The impulse persists until you regain your discipline, and will re-emerge if your discipline is weakened.
If a day trader is trading 200 shares, and collecting small profits, those profits will grow and over time he’ll be able to trade more and more shares (and make more and more money). But if he trades 200 shares, and then suddenly grabs 1000 shares on a particular trade (all else being equal) it has the potential to wipe out a lot of prior little profits if the trade goes sour.
Risk Spikes are a Risk Management Mistake, Win or Lose
Of course a risk spike is poor risk management if we lose. We’ll curse ourselves, feel regret and probably feel angry that we just lost a bunch of money because of an undisciplined decision.
But what if we win? In a way this is worse because it rewards bad behavior. The increase in account capital tells you that you did a good thing. And even if you realize you dodged a bullet and got lucky, since your mistake didn’t hurt you it makes you more likely to repeat it.
A deviation from your trading plan is a deviation, and a mistake, regardless of the outcome. If you can catch yourself, rectify your mistake as quickly as possible. Waiting for an outcome only creates an environment of personal tolerance. Don’t tolerate your trading mistakes, fix them. The best way to fix a risk spike is to reduce your risk to the appropriate level, without hesitation. Don’t think about it, just do it. It may result in a loss or profit, but that doesn’t matter. Fixing the mistake and not giving yourself permission to let a mistake continue into the future is what matters.
Any trade can be a loser, no matter how good it looks when you take it. If you have a lot at risk on a trade, then you could potentially lose all that capital at risk. By fixing the mistake early, you avoid that scenario.
Risk Management Mistakes Beget More Risk Management Mistakes
Risk spikes expose our account to a greater risk than we’d normally allow for a single trade. The fact the mistake happened means something is already a bit off…we lost our discipline and when that happens, if we don’t regain it quickly (and begin exercising discipline again) we often start making more undisciplined mistakes.
Assume you normally risk about $100 per trade, and for your strategy that equates to about 500 shares for the stock you’re trading. Instead of taking 500 you take 2000. The trade starts to move against you, and almost instantly you’re at your $100 loss where you should be closing the trade. You’re filled with regret though, absolutely pissed off, and now all you want is to get out of this trade flat and forget it ever happened. You adjust your stop loss (allow yourself to lose more than you originally planned), because you don’t want to see that loss on your account statement. You decide you’ll give the trade a bit more room to work it’s way back to break-even and then you’ll close it out.
Mistakes are multiplying. The psychological stress of the larger position is now causing other deviations from the trading plan. Soon you’re staring at a $300 loss. You know you should stop the bleeding now, but with a bigger loss there’s even greater pressure to try to get back to break-even. See how a simple lapse in judgement can get ugly fast? As desperation sets in, some traders will average down (increasing a position as it moves against them) or just throw their hands up, cancel their stop loss altogether and basically risk their entire account on a single trade. The inability to take a loss is Loss Aversion, and is a topic all its own.
It’s a slippery slope. One mistake often leads to another, and the more that are piled on the easier it becomes to make another and another.
Risk Spikes – Realize the Severity
Out of all the risk management mistakes, a risk spike (or a series of them) can clean out the account the quickest. Not only does it put a lot of capital at risk on a single trade, but the very undisciplined nature of the mistake means the trader is susceptible to making more undisciplined mistakes when the stakes are highest.
If protocols aren’t in place (See: Day Traders – How and Why to Use a Daily Stop Loss), a single mistake such as taking too large of a position, can lead to other mistakes such as adjusting stop loss levels, and averaging down, making the problem even worse. Traders have lost everything due to a single lapse like this. Don’t let it be you. Rectify the mistake as soon as it happens.
Risk spikes will only bring frustration, regret, stress and an empty account over the long run. Unfortunately, every trader will experience them at some point. The goal in the back of your mind should always be to trade another day. Don’t let anything jeopardize that. If you’re making mistakes on a particular day, stop trading. There’s always tomorrow. Don’t let mistakes snowball into more risk spikes or other risk management mistakes. Have risk protocols which control your daily losses, so no single day ruins you.
Bottom line: mistakes happen, but if you fix them as soon as possible they’re likely to be much less severe than if you tolerate them and allow them to fester into more trading mistakes.
By Cory Mitchell, CMT
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