Planning Trades to Control Risk

The problem with many traders is that they have only half a plan, the easy half. They know how much profit they're willing to take, but they don't have the foggiest idea how much they're willing to lose. They're like a deer in the headlights, they just freeze and wait to get run over. Their plan for a position that goes south is, “Please God, let me out of this and I'll never do it again,” but that's wishful thinking, because if by chance the position turns around, they'll soon forget about their promises.  They'll go back to thinking that they're geniuses, and they'll always do it again, which means that they're sure to get caught, and get caught bad.

I have a true story I’d like to share: It’s about a broker I knew and a Coffee trade he made. It goes like this:

I received a phone call from this guy moaning about a Coffee trade he was in. He was managing money and had all of his clients in this particular trade.

Coffee, at least at that time, was, and still can be, an illiquid and extremely volatile market, and is often best traded by people who have a genuine need to trade there. But he was in and in up to his neck in trouble. He said, “Joe! I don’t know what to do! If the Coffee goes down any more, I’m going to wipe out all of those accounts.” He told me he had been so sure the market would move up that he never even planned the amount of risk he was willing to take, and by the time he had determined where to put a protective stop, Coffee had shot past that point.

I told him I had no idea of how he could get out of his predicament, and that was an honest answer. I really did not know what he could do.

Apparently, he decided to pray! He called me back that evening and told me he had gone into the restroom, closed the door on the booth, and knelt down and implored God to get him out of the mess he was in. He promised that he would never again trade Coffee if God would just save his skin from disaster.

The following day, Coffee opened gap up, and moved to a point where he could get out at breakeven. He took the opportunity and got out. Later that day, Coffee moved even higher. Two weeks later, he was back trading it once again.

The broker had no plan for what he would do if the market moved against him. Whatever planning he did was done after, not before, entry into the market. His irresponsibility took unlimited risk with client accounts, having no idea of his exit point.

But perhaps worst of all, he was dishonest with both himself and his clients. He vowed to never trade that market again. Where were the discipline and self-control he needed to keep his promise?

How many of us do the same thing when we trade. We make mistakes, vow to never make them again, and then do the same dumb things all over again. We take risk without planning, or realizing just how much risk we are truly taking. Then the market teaches us a painful lesson. I think you would agree, markets are very good at doing that.

Author: Joe Ross

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