How Should I Decrease Risk?

Hey, remember when this blog used to be fairly educational?

Well, how about this article, that I have on my fancy website? It's now yellow! But not finished yet. Getting there though. And wouldn't you know it - I have to go camping on the world's largest sand island.

Anyhoo...

Trading, for me, is about minimising risk. And to minimise risk, I follow an incremental approach. The very last step being full-on trading. I mean it makes sense when you say it like that, but it's amazing how often people just jump straight in. (Don't do that).

Step 1 - Backtesting

You've probably read a number of trading books and websites, and in each one there'll be some kind of disclaimer such as "past performance does not guarantee future results".

If this is the case, which it is, then what is the point of backtesting?

Firstly, backtesting can show to you that your idea was an outright dud. I mean, if backtesting shows that your trading system would have lost hundreds of thousands of dollars over the course of a year, surely you aren't going to use that trading system in the real world.

Secondly, you can rank your different ideas against each other, and choose the best of them.

Most importantly, I think, is that while you aren't going to be able to use your backtesting results to predict exactly how much money you'll make in the future, it should be a rough guide. (But only if your backtesting mimicks the real world as closely as possible). Sometimes markets do change personality overnight. Most of the time, however, they behave as they did before. Looking at charts for just a brief time, you should be able to see that EURUSD behaves differently to USDJPY behaves differently to USDCAD. They all have their own unique personality, and it's only a matter of working out how to profit from what you can see.

Step 2 - Paper Trading

Now that you've settled on a trading system to use, the job of proving to yourself that it is actually profitable is not yet over.

Sometimes your trading system will actually not be physically tradeable in the real world. Maybe it relied on your broker filling your orders at specific levels during major announcements. Maybe the results were skewed heavily by one or two fantastic trades, with all the others break-even or worse.

So, the next step is to Paper Trade. This means one of two things: (a) you do absolutely everything the same as if you were really trading, except instead of placing the order you just write it down on paper; or (b) utilising a demo account where you can place real orders, but no actual money is at stake. Currency trading has this advantage that most brokers offer demo accounts.

Now you can see if the backtesting results match reality. If not, then you start at the beginning. If so, you move on to trading in small volumes.

The amount of time spent paper trading is up to you. Essentially you're just verifying that your backtesting was correct, this is a profitable trading system, and you are actually able to trade it yourself.

A word of warning though. After your backtesting has shown good results, you are likely to believe this trading system works. You are therefore going to pay more attention to evidence that backs up what you already believe. And I can almost guarantee that you are going to get a fantastic result from one of the first trades you do on paper.

When that happens you are going to kick yourself that you didn't actually use real money on that trade. You hop straight into real trading, and then come the losers. A dangerous place to be. You believe the trading system works, so you put up more money to win back what you lost. And still the losers come until your trading bank is all but gone. It's very difficult to recover emotionally from this. And that's where the trading life of most people end.

Don't do just 1 or 2 paper trades. A minimum of 20 paper trades seems to be recommended by the experts.

Step 3 - Trading In Mini Accounts

After paper trading has gone successfully, now we can move to trading with real money. However, we are going to start very small.

Now that you are using real money, suddenly our old friends fear and greed come to town. Suddenly you're tinkering with the rules after each loss, based solely on that one trade. "Oh, if I add a 5-day EMA I wouldn't have gotten in on that one!". Tinker, tinker, tinker, and suddenly your trading system doesn't resemble the one you backtested. You lose more money and tinker further. It's a downward spiral.

This is why the paper trading is so important. Without feer nor greed you have demonstrated to yourself that your trading system works. It should cement in your mind that sure, losses do happen, but your rules are solid and the winners are bound to come. Therefore there is no need to tinker.

And, because we are trading in a mini account, or with very low volume, actually we aren't losing so much money if the trading system turns out to be a dud after all. Or perhaps the trading system is solid, just you can't trade it when real money is at stake due to psychological problems. It happens.

Step 4 - Incremental Increase of Trading Bank

You backtested. You paper traded. You traded in small volume. Everything went well. This last step continues forever. If you always risk 2% of your trading bank on each trade, and if your trading bank continues to grow, then you are incrementally increasing the size of your trades. And with increased size of trades comes increased profits. And so on, and so forth. Congratulations. Depending on the website you read, you are amongst the 5-20% of traders who have made it. The other 80-95% probably didn't follow the steps here.

Trading-bots - The Added Risk Area

Adding automated trading software (or a "trading-bot") does so many wonderful things for your trading, most notably the removal of the fear and greed part. However it also adds another risk area.

You are entrusting this trading-bot with your money. Surely you want to ensure that it's going to do the right thing. So during paper trading, not only are you ensuring that the trading system is profitable, you must also ensure that your trading-bot handles a variety of situations.

Does the trading-bot buy when you expect it to? Does it sell when you expect it to? Does it move your stop loss like you told it? What happens when the Internet connection is broken? Power goes out? When the power comes back and the Internet connection restored, does it open another trade when really it should just be managing the one that's already there? Does the trading-bot always use stop-losses? What happens if it doesn't set a stop-loss, the power goes out, and you're at the beach drinking beers?

Test these scenarios while paper trading. If the trading-bot passes all tests, you can let it go in your real trading account with little worry. And then go to the beach and drink beers.