Size Matters

Sometimes you trade the market, sometimes the market trades you. One of the distinguishing characteristics of our business is that our degree of certainty on any given trade is effectively zero. In other areas of life the expectations that event A will produce result B can be as high as 99%. Computer companies often gloat about uptimes of 99.999% or five nines as they like to call them.

Not so with trading.

In our line of work we operate with odds that are much much closer to those of a roulette wheel in Vegas than a computer farm in Redmond Washington. On any given day, at any given moment, even the best researched trade ideas can go horribly awry as news changes sentiment. The brutal truth of our business is that we gamble for a living, but just because we do we must never allow ourselves to become gamblers.

The current issue of the CFA Magazine has a fascinating article titled “The Financial Psychopath Next Door.” Studies conducted by Canadian forensic psychologist Robert Hare indicate that about 1 percent of the general population can be categorized as psychopathic, but the prevalence rate in the financial services industry is 10 percent. And according to Christopher Bayer a well-known psychologist who provides therapy to Wall Street traders, the rate may be higher.

The article notes, “Taken to the extreme, some traders become compulsive gamblers. The behavior is often latent--neither they nor anyone else knows they have this propensity. They hide small losses and keep doubling their position to try to eliminate them. When those trades turn sour, they dig themselves into a deeper hole and deny any wrongdoing or failure. They rationalize by telling themselves that poor investment decisions are an occupational hazard. They lie to family members or others to conceal the extent of their involvement with gambling and commit forgery, fraud, theft, and embezzlement to support their habit.”

The article clearly deals with extreme forms of behavior but it is applicable to anyone who has ever traded an FX lot. We are are all guilty of those sins to some extent. Which is why the longer I trade, the more I appreciate the issue of size. Size matters, but perhaps not in the way you think.

All of us who approach this business with even a modicum of professionalism, set risk limits on our trades. Generally, most short term traders never wager more than 5% on any one single idea if they want to be around for more than a month. But as traders we are constantly tempted by new setups, new patterns, new ideas. This is where size matters most. If you are experimenting with something new and interesting in your repertoire, you should never, ever, ever, allocate you standard trade size to the idea. A good rule of thumb is that you should experiment with new ideas at about 1/5th the level of your standard setup. In other words if your regular risk level is 5% ( way too high in my opinion) then your “try setup” should only use 1% of capital and never, ever, ever a penny more in addition.

In trading, it’s ok to gamble, in fact it is often necessary. But just because we gamble on every trade does not mean that we should allow ourselves to devolve into degenerate gamblers on the market.

Boris Schlossberg

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