Trading psychology: Don’t underestimate the risk

Assessing the risk of a trade is one of the biggest challenges any trades faces when planning the operations. It’s much easier to focus on the potential profits of a big trading opportunity spotted, getting seduced by those big figures, than calculating the potential losses one wrong turn can trigger.

That’s where a lot of mistakes happen, as miss-calculating the risk of a drawdown can have severe consequences to any trading account, no matter the size. Walter Peters, trader and owner of FXjake, admits this was his biggest error:

"My biggest mistake was not understanding probabilities. It's embarrassing to admit, particularly because in graduate school I received a minor in statistics, with an emphasis on categorical data analysis. This is precisely what we deal with as traders (win or lose). Once you understand how probabilities affect your likely outcomes, you can literally avoid the number one "trader killer" which is the dreaded drawdown.

Like many traders, I focused on the end goal (profits) and did not spend enough time considering the effect of a drawdown on my psychology and my resiliency. But once I understood how to project likely scenarios using statistics (and in particular probabilities), everything changed.
You will feel more in control once you calculate your risk of drawdown, because you will know how to avoid it. I would encourage you to 1) identify the draw down you want to avoid and 2) calculate the risk of reaching this drawdown level, so you can continue to trade without running into the emotional brick wall that is the catastrophic drawdown."

Russell Shor, an independent senior markets analyst, puts that into numbers:

“The biggest lesson is to understand the mathematics of risk. A 10% loss is not offset by a 10% gain. Think about it like this: a 50% loss needs a 100% gain on remaining funds just to break-even; a very steep feat indeed. My mistakes have always been overcommitting capital to a single trade. If the trade doesn’t work out it has damaged my trading account more heavily than necessary. Risk control ! Risk control! Risk control!”

That reads as a textbook argument that, once learned, should never be forgotten. But, of course, the odds of getting trumped by risk miss-management get bigger once you get on a good run of trades, developing an over-confidence than can end up with the trader forgetting about its own rules. Dmitriy Gurkovskiy, senior analyst at RoboForex, has a name for this, The “Market God Syndrome”:

“A typical issue is the so-called "Market God Syndrome", which may become a problem of an experience trader, not actually a novice. When a trader has a good winning streak and increases his capital by a few times through a small period, they easily increase the position size and the number of traders they make. As a result, they forget about their risk management system, which may lead to margin call and stop out very quickly after just a few losing traders without any critical movements. It’s something I have faced in my trading career”.

One could also read as “don’t win too much, too quick, too easy”, as it might end up being your own trading grave.