Mastering Financial Pattern Recognition

Chapter 12. Risk Management and Trading Psychology

Risk management is one of the pillars of any trading system, and in fact it may be the most important pillar. Finding a predictive and profitable trading strategy is what will make you money, but a sound risk management system is what will allow you to keep it.

This chapter discusses the subjective part of the trading process and explains the known biases that you may encounter when trading.

Basics of Risk Management

Risk management does not have to be complex. You can create a solid risk management system by using the few simple rules given in this section.

Stops and Targets

As previously discussed in the book, a stop-loss order is an automatic order set during the trade initiation to ensure a minimal predetermined loss. For example, if you buy a few contracts on gold at $1,500 in anticipation that it will go to $2,000, you may place your stop-loss order at $1,250 so that if the price drops to $1,250, you limit your losses to no more than $250. At the same time, your anticipation of selling when the market price reaches $2,000 is known as a take-profit order (target).

The most basic risk management system for any trade is setting proper stops and targets so that you are framing your expectations and limiting your risks.

Note

One rule that you must never violate: always place stops and targets.

Trailing Stops

A trailing stop is a dynamic stop-loss order that follows the market price whenever it goes in the expected direction, ...