Risk management is not just setting stops. A risk management review of your business should involve identification of all risk and establishment of controls or treatments to ensure you appropriately manage that risk. Risk treatments are usually classified into three categories:
- Avoid the risk,
- Transfer the risk to another party, or
- Reduce the risk.
One trading risk that needs to be addressed is identifying the trading environment which proves most challenging to you personally. Which environment is most damaging to your financial bottom-line?
Where do you struggle the most – strong trending markets, slow but wide ranging trends, narrow range-bound markets, wide ranging sideways markets, or any other classification of market environment?
Journaling and reviewing your trading results will help you identify your areas of weak performance, and allow you to then address the risk.
Let’s look at an example…
I struggle the most in trending environments that just persist all session long, such as shown in the chart below.
My natural tendency is to be looking for the counter-trend trades, always trying to fade the move. In many market environments that turns out to be the best way to trade. However, if my market ‘read’ is off and I fail to identify that the market trend is persisting, it means I’m continually taking the lower probability opportunities.
As you can see in the chart above, the price action gave a number of very tempting counter-trend opportunities, especially on the retest of the area of climactic reversal that occurred at 12:07. None of these opportunities led to a reversal though, with the trend persisting, even beyond the RHS of this chart through to the close of the morning session.
So, what are the options for managing the risk that I’ve misread the market and failed to identify a persistently trending day? How could I avoid the risk, or reduce the risk? (NOTE: The other risk management treatment, transfer the risk, is not really an option for the short-term trader.)
(1) Avoid the risk – I could set objective rules that recognize a trending market and then limit participation only to the direction of the trend.
Al Brooks recommends this method. In his observation, trends are always forming reversals that look good but are losers. In a strong trending market he recommends avoiding counter-trend trades entirely, until certain objective conditions are in place to identify the ‘potential’ end of the trend (see his book for more information).
Reversal opportunities can still be identified, but they’re not taken. Instead, as Al Brooks advocates, they’re watched for failure. A failed reversal offers a great opportunity in the direction of the resumed trend, as all the counter-trend traders are forced to exit quickly to minimize their loss.
(2) Reduce the risk – there are several options here, through reduced initial position size, or simply treating all counter-trend trades as a scalp until proven otherwise.
I tend to use a combination of the two choices. I have in place objective rules for defining a fast trend, and will only seek opportunity in the direction of the trend in these circumstances (with some minor exceptions such as through climactic moves into really strong support or resistance). This keeps me on the higher probability side of the market during those faster moving trends, which are by definition more likely to persist than reverse.
Then once the fast trend has ended, based on failure of my objective fast-trend definition, I am happy to take counter-trend trades, however will do so initially with extreme caution. All counter-trend trades are treated as a scalp, with at least partial profits taken at the first expected area of opposing order flow. While this might only give an R:R of 1:1 or so, it’s psychologically pleasing to take something off the table and allows more room for the remaining part to prove itself.
The challenge comes when the trend persists and my natural tendency to keep seeking low probability counter-trend trades leads to a continual fight against the market. This requires more rules, in which I limit the ratio of counter-trend trades to with-trend trades, forcing me to at least look for some with-trend opportunities, or ban counter-trend trades entirely after a certain number of losses or breakeven results.
So, without going into detail regarding my exact rules, that is the concept I use for managing the risk that I’ve failed to identify the market environment that causes me the most problems – objective rules to limit participation against the trend.
Be sure to keep stats to identify your weakest environment, and then consider the opportunities available to either avoid this environment entirely, or reduce the risk of participation.