How to close ‘risk holes’ in your trading

 

Standing in a queue to board the plane at the gate, my children’s minds – never far from a gruesome scenario – turned to plane crashes. They started discussing the possibility of their and their fellow passengers’ imminent deaths, probably a bit too loudly for some more nervous fliers’ comfort.

I asked them what they thought the chances of an accident were, to which my youngest replied that plane travel was actually very safe, and there was probably about 99% chance that we’d all be fine.

“So, if you flew 100 times, there’s a good chance one of those planes would go down?” I asked.

He mulled this over.  “Maybe it’s 99.9% safe?”

The actual figure is closer to 1 in every 11 million flights, with a lot of variation between airlines.

Human beings are dreadful at thinking about probabilities and managing risk in the modern world. Evolution just hasn’t built our brains that way.

But there are ways – some of them stolen from air travel – to make our trades much safer. Maybe not 1-in-11,000,000 safe … or even 99.9% safe – but we can close down a lot of the risks.

Closing the risk holes

How safe is your trading?

You might say that you’ve a success rate of 65% on your trades. Is that your safety rating?

Or perhaps you’ve only ever deviated 15% away from that 65% success rate on any given month – could that be a measure of how safe your trading is?

Both of these are good stats to have … but, to be really safe, we need to plan for unexpected scenarios in the future – not just ones we know have happened in the past.

In air travel, pilots run through lengthy checklists and plan for many scenarios, even ones that seem very unlikely.

By bringing this approach to our trades, we can plug up potential holes we could fall into. These ‘checklists’ fall into 4 categories …

The bum signal checklist

Does your signal meet the grade?

• Does this signal match all the criteria for you to open a trade. If not, why are you considering it?
• Does something look wrong with this signal (when we draw up our trading rules, we may have not considered the particular scenario the markets are throwing you today – is this something you didn’t account for? In which case, you may want to look at making a change to your rules.
• Is there any news of fundamental data coming out soon that could invalidate this trade?
• Is there any level of support/resistance that makes this trade harder to win?

On the whole, as traders, we love getting signals. They make the pound signs spin in our eyes like a cartoon villain. But the reality is that signals are common as mud – there are plenty of them. What there’s a shortage of are great signals. So there’s no reason to accept sub-standard signals. If you’re not sure about it – just sit this one out. There’ll be another one along soon enough.

The technical checklist

I’m not talking about technical analysis here – I’m talking about the software and hardware we use to actually place and manage our trades. While most of the time, these tend to be very reliable, we should never get complacent when our money’s on the line.

• What will happen to my trade if the connection between my computer and the broker goes down? For example, if you have an MT4 program managing an open trade, which has no actual stop level applied to it … and let’s say your Internet connection goes down … and the market suddenly drops … the MT4 program will no longer be managing your close-out. Sure, it’s not likely to happen, but it’s a good idea to always have a ‘disaster stop’ on such a trade, just in case your MT4 is unable to manage the exit.
• If you’re using an EA to manage your trades, then there are other technical things that can go wrong. Is the programming of your EA solid enough to cope with whatever the market throws at it, or will it sometimes throw up errors? EAs shouldn’t be left to their own devices – they need to be monitored to check that they aren’t throwing up errors with trade sizes and parameters.

Although, to be fair, problems with EAs are often down to user error …

The user-error checklist

It’s easy to make mistakes in our trades – even if we’re using MT4 software to run things for us. Checkboxes left unchecked … a decimal point in the wrong place … these details are important.

• Is my stake size correct?
• Are my stops and targets in the right place?
• Have I checked for data/news coming out that means I should be out of the market?
• If using an EA, is autotrading turned on? Does it need turning off ahead of a risk event?

Of course, no checklist can prepare us for every scenario …

The disaster-management list

Even when we’ve meticulously run through our checklists, things can still go wrong, and risk-management is all about planning for the unexpected.

For the pilot, it’s knowing exactly what you need to do when you have complete instrument failure … you’ve just a compass to go by … you’re in a thunderstorm … and there are deadly snakes sliding around the cockpit …

(That may be from a disaster movie rather than a genuine flight-simulator scenario.)

For the trader, it’s about knowing what you’ll do if …

• You’ve accidentally put in the wrong stake or trade parameters
• You’ve lost 10% of your fund
• You’ve opened too many trades and have received a margin call
• Your win rate has fallen sharply for the second month in a row

In thinking about what could go wrong – the only limits are your imagination!

And these questions need more than a tick in a box – they need a plan for how you’ll behave and limit the damage. This kind of scenario is what allows pilots to calmly run through procedures in an emergency, rather than panic and give a knee-jerk response.

That calm, measured response is exactly how we want to be able to react when things go wrong with our trades. It takes planning.

Can a checklist really make you money?

Of course, checklists and disaster-planning won’t make you a winning trader on their own. You’ll need a good trading strategy for that.

But many, many great trading strategies fail because of errors implementing them and bad risk management.

Most of us could look through our trading histories and pick out multiple mistakes we’ve made … trades we staked wrong, trades we forgot to close, trades we should never have taken if we’d stuck to our rules. And, generally, these mistakes cost us money.

A simple checklist, along with some risk-planning can cancel out these losses, and has the power to boost your results, and even turn around a failing trading system.

 

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