Module 12   Innerworth — Mind over marketsChapter 498

Risk Aversion: The Trader’s Fundamental Handicap

Tom has often heard the sage advice, “Cut your losses early, but let your winners run.” He has trouble following it, however. Based on his experience, he thinks letting your winners run is easier said than done. Sure, it’s not a good idea to let a losing trade mount losses to the point that the entire position is wiped out, but it’s hard to hit upon a winning trade, and then, just sit back and let it ride. There’s a strong temptation to take profits immediately. As they say, “Whoever got hurt taking a small win?”



Tom wonders, however, why he can’t let his winning trades just run a little longer. An analysis of his trade diary entries shows that if he could have held out a little longer, he would have made substantially more profits. Many traders hate to lose, and when they see a winning trade materialize, they want to lock in the profits and ensure a win. Whatever you call it, it is still risk aversion. We are quite willing to gamble with losses, but when it comes to wins, we will take a sure thing over a gamble any day. Risk aversion is surely a fundamental weakness of many traders. If it can be beaten, traders can make significantly greater profits.

Why is risk aversion a problem? Why not just take small profits across a series of trades? It all depends on how successful one’s methods are. If one has methods that work with 90% efficiency, then he or she can take small profits and come out profitably overall. Unfortunately, many traders have a track record that is much lower than 90%. Obviously, it is vital for economic survival to make larger profits on their winning trades than they lose overall on their losing trades. If they take only small profits on their winning trades, however, their wins won’t balance out their losses. Thus, it is necessary to avoid selling a winning trade prematurely.

As Tom knows, it is hard to let your profits run. The sting of several losing trades can impact your pride and your ego. Losing even greater amounts of money by letting a winning trade turn into a losing trade is even harder to accept. Your conscience often tells you, “Sell now before it is too late.” There isn’t a simple solution to this problem. Profits are hard to come by in the trading world; it’s hard for many to risk losing a profit once they see they can lock it in by selling early. It may be hard to swallow, but winning traders tend to be those kinds of people who actually enjoy risk.

They are happy to see they have hit upon a winning set of circumstances and they can’t wait to see what happens. They want to push the limits and see if they can squeeze out as much profit as possible. If you aren’t a natural-born risk-taker, however, it will be difficult for you to hold out and avoid selling early. If you are the kind of person who feels uneasy while a position is in motion, you may have to make an extra effort to let your profits run. One strategy is to sell off increments of the position as it rises in value so that you can ease some of the psychological pressure gradually. By taking a few profits at a time, you can feel an ever-increasing sense of safety.

Other circumstances must be present, however. It is essential that you trade with money you can afford to lose. The reason most traders are risk-averse is that they are trading with money they need for basic living expenses. Thus, they are risking their safety and security, and this puts added pressure on them to perform. It isn’t surprising that under these circumstances, one has trouble taking risks once a position starts to increase in value. You can come up with all the rationalizations you want, but if you trade with money you deeply care about, you’ll have trouble risking it, and “to make money, you must risk money.”

It may sound like a cliché but it is true. You must also manage risk, and that’s hard to do if you don’t have a large trading account. An extremely large trading account allows the trader to risk as little as 1-2% on a single trade and still make a substantial profit. If your account balance is low, you can’t afford to risk only 1-2%, and realistically make a profit. You must risk more and there is a real chance that you can easily wipe out your account after a dozen losing trades.

You can’t beat the mathematics. You need money to make money. If you don’t meet these conditions, then you’ll have trouble trading freely and openly. You’ll worry about losing and you can’t take the big risk when you hit upon a winning trade setup. Unless you are a natural-born risk-taker, you won’t be able to let your winners run. Risk aversion is a handicap. It’s hard to beat it, but some do. If you are one of the few lucky ones, you’ll realize substantial profits and trade consistently and profitably.

Comments are closed.