Reduce invisible risk and reduce outsized losses

What you can't see and test can kill you

risk management

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You can eliminate the risks you can’t see by removing names from your “watch list” or data that you’ve raked – the step before you run the data through your simulator.

Carbon Monoxide of Trading

Pro traders focus on “not losing” rather how much they can make. Of course we need to make money, but by preserving your capital and focusing on defense, you put yourself in a position to appreciate your money emotionally and financially. 

Two invisible risks that you should be concerned with are below:

  • Correlation risk
  • Volume and Liquidity

You can reduce correlation risk by NOT having all the metals in your data source. You can “rule out” correlation risk by saying “if long gold, don’t take trades in silver,” for example. Or, you can set a max risk per group, ie, social media companies, metals, softs, interest rates, so that one group or name will not become unwieldy.

When the markets turn, they will turn for the whole group. If you have large positions of highly correlated assets, you might be in a spot risk-wise to give back more than you want to…and that’s having placed definitive protective stop orders in the market to get filled – it’s worse if you use mental stops. 

Volume is what you saw traded yesterday. Liquidity is what you need to offset your position when you need to do so. Big difference. The invisible risk here is that thin markets move sharply. Sometimes you have to get out of your position when the market will let you out.

You don’t want to be in a position to take larger losses when the market turns on you because everyone is on the same side of the market. That’s the case with Bitcoin right now. When you’re looking to sell, who will be there to buy? 

You can rake your data to include only names that have a set criteria of trading volume so that you avoid problems before they arise. Commodity markets like oats, lumber, and cocoa can be problematic in that regard. Cocoa is not necessarily thin, but it does not have a daily trading limit so your loss potential can be much greater than you’d imagined when building your system. 

Conclusion

When you focus on “not losing” you’ll begin to uncover more and more of your blind spots as the markets and your trading evolve. Losses and drawdowns are part of trading, but by incurring small losses, you’ll be in a better place emotionally and financially to lessen the effects of the magnitude and duration of the drawdown.

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