Traders often take larger positions than they should because they are experiencing size envy. Position size envy occurs when your ego whispers to you, "The sky's the limit." You may be in an environment in which other traders are taking positions larger than yours. You decide that if they can do it, so can you: You jump in without sticking your toe in the water first. If the water is ice cold, you could be in for the shock of your life. A trader's risk tolerance develops over time, given experience, confidence, and the emotional and financial ability to withstand losses.
Someone who can trade large positions has arrived at that point through a long and painful learning process. Most people cannot walk into a gym and bench-press 300 pounds if they are used to putting up only 150. The only way to get to the 300-pound mark is to slowly build up your strength and tolerance over time through a gradual increase in the weight lifted. The same holds true for increasing your position size. It should be a slow process based on your financial capacity and psychological and emotional development, discipline, and strength. Traders should judge themselves by their own goals and nothing else.
One reason traders take positions that are too big is the almighty greed instinct. Greedy traders have an insatiable attachment to money. Remember, the most successful traders on Wall Street have a disregard for money. When you are glued to your P&L as a trader, your ability to act objectively is limited. Everyone experiences greed to some extent, but traders have to keep this human trait under control. Attachment in trading is detrimental because it represents emotionally charged subjectivity. The fewer associations and attachments a trader has, the better.
Emotional attachment to money and what it represents is the main reason traders freeze and have a difficult time taking losses, especially large ones. They find themselves in situations they're unprepared for financially or mentally. One of the hardest things for a trader to do is to stick to a game plan when emotions blow things out of proportion. A trader who freezes is unable to act or think quickly. This hesitation usually makes the difference between a profit, a loss, or a huge loss.
Another reason why a trader might have a position that is too large is because he adds to a loser, or averages down. Adding to a loser is probably the most deadly sin in trading, but the vast majority of traders do it at one time or another. Many do it out of sheer hope or desperation, refusing to acknowledge that they were wrong. Adding to a loser is the worst excuse for a trader to have a position that is too big. Wishful thinking and hoping to make back what was lost often result in huge losses. A snowball effect is created, gaining size and momentum in the wrong direction.
One way to avoid adding to a loser is to realize that you can always cut your losses now and get back in later. Successful day traders are constantly selling stocks for small losses and reentering the position when they think the momentum has begun to move in their favor. Successful traders add to winning positions, not losing ones.
If losses set in that are above your risk tolerance, it becomes much harder to act quickly and to face the truth that you are wrong. As your account accumulates money, your position sizes should increase gradually. This will allow you to slowly build up your risk tolerance based on financial soundness. Position size in trading should be dictated by risk control, not high hopes. The anguish of being wrong in a trade grows exponentially when your positions get out of control. If the mind and wallet are not accustomed to taking large hits, it becomes very difficult to act swiftly and to cut your losses.
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