A risk management process for a trading system is not just math but also includes human psychology. The psychology of execution is just as important to profitability as the trading dynamics of the entries and exits of a trading method. Humans have fear, greed, and egos and these elements can interfere with the process of trading the right position size, cutting a loss, and letting a winner run.
The following are the dangers of risk that come from a trader’s psychology.
- Believing too strongly in a trade can lead a trader to trade too big a position size when they think something must happen. Nothing is certain and position sizing has to be kept within risk guidelines at all times.
- The fear of losing money can make a trader not exit at their preplanned stop loss and keep holding and hoping a trade reverses back to at least break even so they can get out. This back to even trade exit is what can create resistance on a chart in a market that is in a downtrend. If the chart stays in a downtrend then not taking the stop loss when it is small can turn the trade into a big loss.
- The larger the position size the more difficult it can be to follow a trading plan. Trade a size that you are comfortable with in both losing trades and winning trades so you can stick to your plan.
- A trader must embrace uncertainty in any trade. Anything can happen and you have to have a plan for each contingency. Accept that you don’t know what is going to happen and risk is always present. Cognitive bias, certainty, and ego can cause traders to abandon risk management because they think they know what will happen next, they don’t, and the first time they are wrong can be the end of their trading account if they don’t manage risk.
- The fear of missing out (FOMO) can cause a trader to forget about their entry signal and chase a chart to higher prices too late in a swing or trend. FOMO can cause a trader to enter with bad risk/reward ratios because they are afraid of missing out on profits.
- The fear of losing open profits in a trade can cause a trader to exit too early in a trend for a small win and miss out on a big win if they let a winner run. A trader should exit a winning trade when there is a good reason to, like a profit target is reached or a trailing stop is triggered not just because they don’t want to lose their small profits. A trader has to risk small open profits if they want a chance for big profits.
- A trading plan has to be written when the market is closed so you don’t do anything emotional when the market is open. Part of a trading plan is risk management guidelines, it can be difficult to always make good trading decisions when real money is at risk and prices are changing every second and emotions are kicking in. A trading plan can give you a quick filter on what to do.
- An ego can cause a trader to hold on to a losing trade because they don’t want to admit they are wrong. The more people a trader tells about their opinions, predictions, or positions the harder it is for them to exit when they are wrong.
- A trader must have faith in their self and their system to execute their trades without excessive stress. High stress can lead to bad decisions on entries and exits. A trader needs to develop a system that they can use to trade through the ups and downs of their equity curve without being stressed out all the time.
- Bad trading psychology allows emotions, stress, and ego to override a good trading system. Good trading psychology is the ability to follow a good trading system with discipline long enough for the edge to play out and create profits.
Egos are terrible risk managers and emotions are terrible trading signals. A trader has to have the discipline to overcome their fear and greed and follow proper position sizing and stop loss strategies to have a chance for profitability. Most traders fail to make any money in the market because they can’t manage their fear, greed, stress, and ego and this causes them to create bad risk management practices. A good risk management process minimizes losses and maximizes gains. A risk management plan helps guide your decisions based on your trading system guidelines and risk of ruin not your ego or emotions.