Page 385 - THE MARKET WHISPERER

THE MARKET WHISPERER 38 1

Risk Management and Loss Management

First, we need to define “risk management” by distinguishing between two
areas that most traders mistakenly tend to lump together: risk management
and loss management. Correct loss management is a stand-alone theory
having nothing to do with risk management.

Risks must be managed under the assumption that part of our trading
activities will lead to losses. Correct risk management should limit us to
absorbable losses, which we will need to manage separately according to
a different set of rules.

Figuratively speaking, risk management is how a pilot plans to avoid
an accident, whereas loss management is how the pilot must execute an
emergency landing.

Fundamental Capital Risk

How much money did you deposit in your trading account?
What percentage of your trading capital are you willing to lose?
How much of that figure are you willing to lose in one trade?
Before you start trading, you must have clear answers to these questions.

They will help you define your trading strategy. Each of us has different
red lines based on our backgrounds, psychological capabilities, financial
soundness, and monetary commitments.

Define the percentage of trading capital you are willing to lose. This
figure is your first red line. Many of the traders I know have never defined a
red line, and sometimes become aware of it only when they actually reach
it. This is a big mistake: setting limits in advance will help you cope better
with the psychological aspect of trading.

Psychological Risk

Willingness to absorb risk does not derive from our financial status, but
rather from our psychological stamina. “Hating to lose” features strongly
in research which unequivocally concludes: we hate to lose far more than
we love to win, at a 2:1 ratio (Kahneman & Tversky, 1991). Research
indicates that loss is perceived as a change in our financial wealth relative
to a neutral status. Each of us has a different relative status, derived from
both our actual financial status and our perception of the significance of
loss. For example, when we buy stock at a higher than normal price but
do not sell at a profit, we tend not to see the buying stage as an expensive
error, but rather focus on our lack of profit when we sell.

By contrast, when we buy an item at a higher than usual price for