Risk Management

Risk management is a subject that is so broad that the only thing I can do is to encourage others to read widely on the subject. The best places to look for information on risk management are the books written by successful gamblers. In general, risk management involves those actions taken by you that increase or decrease you chances of losing.

Entry into trades under the following conditions increase your chances of losing, thereby increasing your risk: 1. Fast Markets 2. Thin markets 3. Abnormal tick size 4. Day's before a holiday. 5. Staying past First Notice Day. 6. Highly volatile markets. 7. Poor brokerage. 8. Insufficient floor access.

One of the best books I have found on this subject is The Track Attack, written by Clark Gary, and available through Ross Trading for $89.95. Clark Gary is my nephew, a professional horseman, and a steady winner at the tracks since he was 15 years old. Why? He is a master at understanding risk. I can honestly say that he has never had to have a job. At age 30, he continues to make his living at the track. Now how about that for a nepotistic, patronizing plug? In his book you will see some small sections I let him borrow from Trading by the Book. Other than that, the material is all his own.

Traders should strive to become masters at risk management.

Money management and risk management are part and parcel of each other. They overlap, and yet they are different. Defining that difference is rather difficult. Perhaps they are two sides of the same coin. Risk management says, "I can afford to risk only so much." Money management asks "What can I expect to make for the risk I have taken?"

I'm willing to risk an amount equal to average volatility in gold. Now, what can I expect to make for that risk? I have to have my priorities straight here. To the best of my ability, I have limited my risk. Now I can look forward with greedy eyes to how much I might make. But first things first. Before I can make anything, I have to cover costs. Costs in this business are made up of several items.

There is slippage, there is commission, there are fees. These are obvious, direct costs. But what about indirect costs? I've got to cover the cost of my data feed, exchange fees, software, hardware, and my time. Surely my time is worth something.

The broker's time is worth something. I know that every time I see how much he butchers my earnings. How about my time as a trader? Is my time worth something? It had better be, and I had better realize that. What about the costs of all the other books, systems, paraphernalia, subscriptions, etc., that one buys to supplement his education in trading?

Others have made a fortune off of my trading - I had better do so, too. If I don't, it would be because I never learned how to really count the cost. The real cost of trading is staggering!

Yet so many I talk to, even professionals, call it a "game." If this is a game, then it is one of the most dangerous games in the world. My financial life is at stake here. Not only that, my self-respect, my self image, my whole outlook on life can be destroyed in this so-called game.

Trading is a business. The sooner one treats it as such, the sooner one will become a winner. If I'm not a good businessman, I will not be a good trader. I have to understand risk, and I have to understand how to turn a profit.

Here is how I typically manage my money, with slight variations as to the number of contract sets I liquidate to cover costs:

• As soon as I see sufficient gain on one or two contract-sets, I liquidate those contract-sets. That covers my direct costs for the remaining contract-sets. Depending upon how fast the market is moving and the angle of ascent, I then move my stop up to one of two places -either to breakeven (my fill price - I've already covered direct costs with the first contract-set), or to a place where I'm not risking any more than what I originally risked per contract upon entering the trade.

Here's an example: I'm long gold at 360.00. My initial protective stop is at 358.50. The market moves up to 361.00. I liquidate one contract-set at 360.90. I have now earned $90 per contract in the contract-set to cover my costs. If I liquidate two contract-sets, I will have also earned a small profit.

Now it's time to move my stop(s). I can move my stop(s) on the remaining contract-set(s) to 360.00. That is breakeven. I already covered my direct costs when I liquidated the first contract-set.

I can move my stops to $150 (average volatility for gold) away from 360.90, placing them at 359.40. That way I'm still risking $150. Let me repeat that. I'm still risking $150, not the $60 that exists between 359.40 and 360.00.

I can do a combination of the above. Place a stop at 360.00 breakeven for one contract-set, and a stop at 359.40 for the remaining contract-set.

At $90 for the first contract-set, have I made a profit? No! How about at $100, $120? No and No! All I've done is covered direct costs. If my costs in commissions and fees were $60, I now have $30 left over - so I've made a profit right? Wrong! What about that data feed, software, books, systems, and subscriptions? What about my time? I haven't made a thing yet!

• So where does the profit come in? If gold moves up another $80-$ 100, I will issue a market order to liquidate the second or third contract-set. I was long this contract-set at 360.00. Gold is now at 362.00. With a market order filled at 362.00, I will make about $200 per contract in the contract-set. Now am I making a profit? Well, maybe. Maybe, just maybe, I've covered my indirect costs. A big part of that depends upon how much in the hole I am from prior losing trades. Aha! I've finally gotten around to that! The truth is, I haven't made a thing until I cover past losses. Past losses are a part of my overhead. Even the revenue service will agree with that. They let me take those past losses off against current income. For some, past losses are a mighty big hole to have to climb out of.

"Yup!", someone will say, "I'd have to live to be a hundred and win every day to make up for all my past losses." Sorry. But it's never too late to stop playing the futures "game," and start running one's trading as a business. I sincerely hope and pray this book will help my readers to do that.

• So, what about that last contract-set? At 362.00,1 have $200 of unrealized profit. Where do I put the stop? "I want this baby to bring home the bacon. Boy, I have a lot of high hopes for this last contract-set. Maybe I should put the stop far away so this one can really run, right?" Wrong! That's dreaming, that's playing the game. I want to do this in a business-like manner. I don't want to gamble. I'll put the stop in a place where, if I have to be stopped out, I will have at least something for the risk I've taken. I'll put the stop at 361.00 and lock in a guaranteed profit of at least $100 per contract on this last contract-set. I'll never risk more than 50% of my unrealized profits.

• Okay. Now, what if my last stop doesn't get taken out the next time the market retraces? Then I can keep moving my stop up. There are several ways to do it. I can maintain a stop that is always $150 away from the most recent high that this market has made. I can move my stop up $50 every time the market moves up $100. I can keep moving my stop to just below the low of the last market retracement prior to its continuing to move in a profitable direction. I can trail my stop at one or two ticks on the other side of a moving average that is showing containment of prices. Where I do this is a matter of choice.

With my risk and money management philosophy in mind, let me review my short trade in the crude oil.

CL 5 tllMUTE

The market opened at 3400, moved up slightly, and then took out the low of day 1 (3390). I was waiting for it at 3389 and got filled at 3388. I took my first profit at 3377, and my second profit at 3365. I then held on with one contract to run. The oil never really ran. It went down to 3340, and then began a major upward intraday recovery.

When prices had reached 3340,1 moved my stop to protect 1/2 of my unrealized paper profits. At 3340, I had 48 points per contract in the crude. I moved my protective stop to 3364, and bought it back there, netting 24 points.

I want to share an amazing statistic. I have this on good authority: In any given trade in any market, 80% of the traders enter on the right side of the trade. Yet, the vast majority of those traders will end up losing money on the trade. Why? Because they will sit there stewing in their greed, and watch their profits fritter away. They will not take profits! They will try to milk just a bit more out of the market. When the market moves away from the most profit they have seen, they will hold on in the hopes that the market will move in their direction just one more time.

Instead, the market will move against them, perhaps gradually or perhaps suddenly. In any event, the traders who didn't take profits will now be on the defensive. They will be facing a

CL 5 tllMUTE

360© 359© 3580 35?© 3560 35SO 354© 3S30 352© 351© 35G© 349© 348© 347© 346© 345© 344© 343© 342© 341© 340© 339© 338© 337© 336© 335©

breakeven or a loss. They may even commit financial suicide by moving their stop ahead to meet the onslaught of the price action. Before they know it, that fatal tick will have arrived, and they are out with a loss. If I have just described my reader, then now be aware that there is a way to circumvent these losses - they don't have to happen to anyone.

Do I do as I have said? Do I take the profits while they are there? Do I take them systematically, and on schedule? You'd better believe it. I've just shown how to do it. Need I say more?

1 have a little friend. That's my friend over there on the right. I protect him as best I can. When I go to market with him, he has a tendency to wander away and get lost.

There have been times when I lost him, and it caused me great pain and grief. I don't ever want to lose him again. Most people have one just like him. Have they been losing theirs? If they have, then they'd better protect theirs as I do mine.

Chapter 15 CONGESTIONS ARE IMPORTANT

Let's review some material we've covered, and then move on to another refinement.

Upon entry into a market, I want to trade a breakout brought about by any one of my major or intermediate signals.

For actual entry into such a trade, I want to trade the breakout of any congestion that existed just prior to my entry point. That way I can get into the trade very early or somewhat early.

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