The past decade has seen huge changes in the way people can and do participate in the markets. The financial crisis, algorithmic high-frequency trading, and the sense that the playing field isn’t level have all taught individual investors and traders a powerful lesson: prepare for the worst-case scenario. Fortunately, limiting the downside can be a way to maximize the upside.
By Vikram Rangala
Thursday, March 24, 2016
Recent reports that many brokers and financial advisers don’t act in their clients’ best interest have a lot of investors asking questions. Even if your advice comes from a trusted fiduciary, who isn’t being paid to promote some investments over others, there’s still a question you probably aren’t asking, that you should be asking. If you trade on your own, it’s even more important that you ask yourself this question.
WHAT’S THE EXIT STRATEGY?
Actually, make that strategies, plural: one for profit-taking, one for loss-taking. It’s such a basic question a lot of us think it’s not sophisticated enough. It’s sexier to talk about earnings and P/E ratios and undercapitalization. Or to talk about stochastic oscillators and moving averages.
Why don’t we talk about what we’ll do if a trade doesn’t go our way? Because we don’t like talking about losses. It sounds too much like lose, and loser—words we don’t want to be associated with. Tell the truth to anyone who wants to get into trading and you have to start with, “You’re going to lose a good percentage of the time, but that’s okay.”
That’s a different mindset than the one you find in ads for systems with “80% winners!” It’s not good marketing to say, “40-60% winners and you can be profitable if you limit risk.” But it is good trading.
That’s why at Nadex we put the maximum possible loss right on your order ticket. You know what you can lose in each trade before you enter it. And you also know that there’s a limit to that risk, built into the design of your Nadex binary option or spread.
Whatever you trade—stocks, futures, forex, or exchange-traded binary options and spreads—ask yourself, do you have a stop-loss or hedge in place for when (not if) the market moves against you? And are you committed to taking that managed loss?
HOW DO YOU PLAN TO TAKE LOSSES?
You’ve probably heard the old trader’s maxim, “Take care of the losses and the profits will take care of themselves.” You can literally make that your approach to every trade.
How? Don’t think about how much you will make. That comes later. Plan your loss strategy first. Limit risk first. Make sure that if and when your losses come (and they will come) they won’t wipe you out or keep you from coming back to trade again.
There’s also another way to think about your profit-taking strategy. Once you have made gains, it’s easy to start dreaming about how far a trade could go, hypothetically. You can start thinking about huge profits that are theoretically possible, but unlikely. Experienced traders don’t think about that. They think about how to get out without giving back your gains.
BASE HITS, NOT HOME RUNS
It’s a different way of thinking. You give up the idea of hitting home runs one after another. Remember that Babe Ruth was not just the home run king of his era. He also held the Major League strikeout record for 30 years.
Instead, consciously plan the loss scenario first. Of course you want to take trades that give you an edge, where you have, say, a 60% chance of the market giving you the outcome you want. Plan for the 40% of the time when you have to take a small, manageable loss. And plan to not hand back the money you made as a result of that edge.
Again, this strategy works for all types of trading, but Nadex binary options and spreads have built-in profit targets by design. You have a maximum profit goal built into the trade for you. And you still have the flexibility of exiting the trade early instead of waiting for the maximum possible profit. That’s why Bloomberg Businessweek called Nadex the “future of trading.” There’s some good trading strategy and risk management baked in before you click “Place Order.”
Whether you trade a product where it’s built in or a more traditional instrument, to do this consistently you have to manage your fear and greed. Manage fear so you protect yourself instead of avoiding the basic truth that part of trading is taking losses well. And manage greed so you can embrace the base hits, the small consistent victories that add up to long-term success, and give up the need to win the lottery every time.
Trading is best treated as a business and risk management is the first priority in the success of any business. You wouldn’t open a restaurant without buying proper insurance and having a plan that depends on steady customers, not big parties at random times. It’s not much different to have a trading business that remains consistently profitable. If that sounds boring, good! Good traders have another old saying, “If you want drama, go to the movies.”
This information has been prepared by Nadex, a trading name of North American Derivatives Exchange, Inc., prepared by independent third parties contracted by Nadex or reproduced form third party news agencies. In addition to the disclaimer below, the material on this page does not contain an offer of, or solicitation for, a transaction in any financial instrument. Nadex accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.