Understanding 'Risk Management & Trading Psychology'

Lesson -> The Position sizing for Active Trader

11.1 - The Poker face

I had the opportunity to play poker last month with some good friends. After a 6 year gap, I was excited to play poker again. This friendly game had a buy-in of Rs. 1000. Poker is a card game in which skill and luck are both tested.

The game began, cards were dealt and I placed a bet of Rs.200/-. I watched it disappear, exactly as I had hoped. The next round I placed another 200 bets and it disappeared again. At this point, I was convinced that I could make up my losses from the 3 rd round. I then increased the stake to 600 and watched it disappear! In all honesty, I lost Rs.1000/in a matter 10 minutes. This is the equivalent of blowing up your whole trading account in trading.

I did not give up. After all, trading and poker have many similarities. I decided to "recover" my first loss and continue playing the game. I purchased it again for 1000, and began fresh. I was able to stay on the table for 15 minutes this time.

It was clearly not for me. My memory of playing poker six years ago was better. Although not my best memory, I was able to stay at the table for the entire game and win a few hands. What was the deal this time? This was all I could think of. How could I erase my account twice in 25 minutes?

After having a lot of confusion about my poker skills and current game, I decided to buy again for 1000 Rupees. This was my third rd purchase-in. This is the equivalent of funding your account 3 rd times after blowing it up two more times.

What advice would you offer someone who has twice blown his account in the markets? Perhaps the best advice would be to 'get out the markets immediately'. But I ignored my inner voice. The gambler's fallacy had overtaken my rational thinking and I bought again for 1000 Rupees.

If you don't understand the gambler's fallacy, it is when you bet on an outcome and have a long streak or losses. Your mind tricks you into believing that your losing streak is over, and that your next bet will win. This is when your betting volume increases and you lose more money. Gamblers are one of the most common culprits in the destruction of many trading accounts.

Now, let's get back to the poker game. This was my third rd purchase, I had already lost 2K, and was now betting with 1K. I was optimistic that I would recover, make money, and not be shamed. But the guys at the table had other ideas. They knew I was a sucker at the table, so it was easy for them to seduce me into making irrational wagers. They did so and cleaned me up in the following 7 minutes.

After losing 3k, that was it.

I thought about what had gone wrong after the game. I knew the answer.

  1. I didn't realize the chances of winning with the cards dealt to me.
  2. I didn't 'position-size' my bets. My bets were too random and irrational.

After waiting a few weeks, I received another invitation to the game. I had a bad record of giving away free money. I decided this time to place my bets correctly.

It cost me 1000 dollars and I started playing. I was able to assess my odds and place a bet if they were fair. This was similar to using a 'trading strategy' that is supported by position sizing. This simple, systematic approach made a huge impact on my trading game.

  1. I won a few hand
  2. At the peak, I had approximately 4K in winnings
  3. I persevered through the game and had lots of fun.
  4. I lost some of my gains towards the end but was very happy that a few simple strategies helped me better manage my game.

This game was all about position sizing. It does every time and that is why I am telling this story. I don't want you to gamble in the markets without knowing your odds and without sizing up your positions. If you do, you'll make a fool of yourself

While poker is fun, trading can be a serious and important way to make your money. Please Sharp Focus to the following chapters. It will positively impact your trading career, I am certain.

This is where I must mention that I learned position sizing from Van Tharp many years ago. Van Tharp was the first to introduce the concept of positioning sizing to traders. To further your knowledge, I recommend that you read some of his books.

11.2 - The Gamblers fallacy

The gambler's fallacy was briefly mentioned in the beginning. It makes sense, especially when you consider markets, to talk about this more at the beginning.

This chart will help you to understand the importance of -

Image 1

This is the chart for Nifty. Nifty reached the magic number of 10,000 on the 25th July 2017. How would you trade this as a trader?

  1. Nifty has reached an all-time high of 10K
  2. This psychological level is where many market participants could book profits.
  3. Resistance points are not possible at all for an all-time high
  4. Over the past few weeks, Nifty has shown a strong upward trend
  5. Perhaps Nifty will consolidate at these levels?
  6. Perhaps a correction of 2 to 3 percent before the rally continues is possible?

Let's just say that these points are valid for now. This implies that a short position or buying puts is possible. This analysis can be as straightforward as it is or as complex as studying time series data and modeling the same using advanced statistical, machine learning, or other models.

Markets are unpredictable, regardless of your actions. There is no one way to predict the outcome. This means that you are dealing with random draws. Your odds of winning may increase depending on how insightful your analysis is. However, you must accept the fact that there is no guarantee and markets are random.

Imagine this: You have completed a state-of-the art analysis, and you place your trade on Nifty. However, you do not see the stop loss trigger. You don't give up and place another trade. Unfortunately, this time you are again stopped. The cycle continues for the next four trades.

Your analysis is correct, but your stop-loss triggers constantly. You have money in your account for bets. However, your analysis is still sound.

  1. Are you ready to stop trading?
  2. What would you do if you had to risk the same amount again?
  3. After losing 6 consecutive bets, do you think your chances of making money on the 7 th trade are higher? If so, increase your bet size in order to recover your losses and reap some profits.

Which choice are you most likely to make? Give it a chance.

I have been in this situation and interacted with traders, and I can tell you that most traders would choose the 3 rd option. The question is, however, why?

Traders believe that losing streaks will end when they trade the next trade. In this example, the trader had suffered 6 consecutive losses but is convinced that the 7 trade will win. This in general known as the Gambler’s fallacy.

When dealing with random draws, your chances of losing on the 7 th trade are as good (or worse) than when you first placed your bet. Even if you lose a few times, your chances of winning the next trade are not better.

Gamblers Fallacy is a trap that traders fall for. They increase their bet sizes and don't understand how the odds stack up. Gamblers fallacy is the main culprit in the destruction of trading accounts.

The same principle applies to the reverse side. Imagine that you have the opportunity to witness 6 or 10 consecutive wins. The trade will work in your favor no matter what you wager. Now that you are on your 11 th trade, which one of the following is most likely to be yours?

  1. If you had enough money to trade, would you quit trading?
  2. What would you do if you had to risk the same amount?
  3. Do you want to increase the size of your bet?
  4. Do you prefer to be conservative, protect your profits and reduce your stake?

You will likely choose the 4 and the 5 options. You want to protect your profits, but you don't want to lose what you have earned in markets. However, you might also want to trade if you have a winning streak.

Again, this is the 'gamblers' fallacy at work. You are effectively reducing the size of your position for the 11 th trade by being completely influenced and influenced by the results of the 10 previous trades. This trade is almost as likely to win or lose than the previous 10 trades.

This may explain why traders who are successful in trading end up making very little.

Position sizing is the antidote to 'Gambler's Fallacy'.

11.3 - The Recovery trauma

The raw material in trading is the capital that we bring to the table. How can you make a profit if you don't have enough money? We need to protect not only the profits we make, but also the capital.

This thought can be extended to the extent that you could risk too much capital on one trade. You may lose your capital and leave you with very little. If you trade with very little capital, every trade you make will seem too risky. It will take a lot of effort to get back to the point you were (in terms capital).

To help you understand this fact, I have created a table. Let's say you have Rs.100,000. Let's see how these numbers compare with -

Image 2

Let's say you lose 5% of capital, or Rs.5000/=. Your new capital is Rs.95,000/. You need to earn a return of 5.3% to reach Rs.5000 and a capital of 95000 to recover your losses.

Instead of losing 5%, let's say you lose 10% and your capital is 90000. Now you need to make back 11.1% to get 10000, or 10%, of your original capital. As you can see the loss gets more severe, it will be harder to get back to your original capital. At 60% loss of capital, the chances of a 15% bounce back are very high.

The'recovery trauma" affects traders with smaller accounts. Let's say you have Rs.50,000 capital and go to the market. You would have heard about Rakesh Jhunwala's success in growing his money from 10,000 to over 15K crores. This success is something you would like to emulate at least in part. If you are able to grow your business from Rs.50,000 to Rs.60,000 per year, then you have done a fantastic job. This is a 20% return. This isn't exciting, right? It doesn't seem fair to earn Rs.10,000/- in a year if you are trading.

What do you do? You take greater risks in the hope of making bigger profits. If the trade does not go your way, you could fall prey to the "recovery trauma" phenomenon.

You shouldn't risk too much on one trade, especially if your capital is small. Your chances of making money in the markets are high if your stay is long enough. To stay longer, you must have enough capital. And to have enough capital you must be willing to take on the appropriate amount of risk for each trade. It all boils down to achieving long-term consistency in markets. To be consistent, you must position size your trades well.

This chapter will be closed with a quote by Larry Hite.

Image 3

In the next chapter, we'll be looking into more advanced techniques for position sizing.

To Summarize

  1. A trading system's cornerstone is its position sizing

  2. The gambling fallacy is an incredibly applicable bias in the trading world. This bias makes traders believe that any long streak of a particular outcome can end.
  3. There are infinite draw opportunities, so the chances of making a profit on the N th trade are similar to those of making the same profits or losses on the 1st trade
  4. Recovery of capital can be a much more challenging task than you might imagine.
  5. Smaller traders are more likely to place larger bets than they should.