Safe Guarding Your Financial House

Successful trading involves getting a grip on your emotions. Unfortunately, most traders never seem to focus on this crucial aspect. However, professional traders who take 90% of the profits from others pay attention to their emotions.

Our goal should not be to eliminate emotions from our trading because we are humans, and that would be an impossible feat to accomplish. But we do need to keep our emotions under control. Otherwise, we will throw caution to the wind and possibly abolish our trading account by losing all of our money.

Many novice traders have never experienced a significant loss in the markets yet. All traders will, at some point, have that considerable loss that will haunt us throughout our trading career. Though the saying in motorcycle riding, "There are only two types of motorcycle riders – those that have crashed and those that will crash," also applies to trading.

If you are lucky to have experienced this loss, I would like you to remember that day and your emotional state. Yes, I said "lucky ones" because now you have been there and know what to expect and how you will react if you ever get close to that emotional state again. For traders who have yet to have this experience, you still need to learn what your reactions will be when it does happen to you. Will you become a revenge trader in an attempt to recover those losses? 

To help understand how cool heads can prevail during these emotional moments, I would like to compare Limit Moves on futures exchange-traded products and a Daily Max Loss for individual traders. Let's see if understanding these two safety mechanisms can help keep your financial house from burning.

Futures exchanges have had their version of an emotional circuit breaker for years in some markets. They are called Daily Limit Moves and currently apply to the grain, livestock, and stock index markets. All other markets have Circuit Breakers that temporarily suspend trading if prices rally or drop a significant percentage move too quickly.

In the grain, livestock, and stock index markets, the futures exchanges have implemented a pre-defined range for the next trading day. The results would be to stop trading in the direction the market moves to these Limit Moves. For example, corn has a Daily Limit Move of 45 cents per day above and below the previous day's settlement price. If the price reaches these extremes, the exchange will halt trading in that direction. The market is free to move in the opposite direction but cannot trade beyond these Limit Move prices for that day.

For many years the exchanges had Daily Limit Moves on almost all of the markets. Today they remain primarily on the agricultural and stock index products. The purpose of a Daily Limit Move is to allow traders to stop trading with so much emotion. Prices get to these Daily Limit Moves through excessive supply or demand entering the markets. 

A good illustration of that is that the average daily range in corn has been about 10'0 cents. The corn market would have to move 45'0 cents above the prior settlement to trigger a Daily Limit Move, which would be 4 times greater than the average day. Another way to look at these moves is from Allan Greenspan's "Irrational Exuberance" speech. He stated his reasons for raising interest rates were to cool down the unreasonably bullish emotions that had taken over traders' brains, which could have led to harmful trading/investing decisions. 

The exchanges felt it was good to halt the trading for the day when these Daily Limit Moves were triggered, encouraging traders to leave the trading pits and their screens. The hope is that they will go home and come back the next trading session with cooler heads, able to make less emotional trading decisions.

Another form of a Daily Limit is for a trader to establish a maximum loss per day, week, or month rule, depending on their trading style. Traders must write this down in their trading plan as unwritten rules are difficult to follow consistently during the heat of the moment in trading.

The trader's Daily Max Loss Limit could be a percentage of their trading account in dollars or a defined number of daily losses. The main thing is that you quit trading when you have hit this loss. Any professional trader will tell you their objective is to be able to come back and trade tomorrow. Most novice traders think the opposite and want their money back that day regardless of how poorly they are trading or erratic the markets may be that day.

Think of this Daily Max Loss Limit as a circuit breaker in your financial house. Just like in your home, if there is an electrical short somewhere, the breaker will kick and prevent your entire house from burning down. This same analogy applies to your financial house; you should have the same protection as your house. If we do not respect our money, our money will not respect us.

Once a trader has a more significant loss than usual, they can have an uncontrollable fear set in. This fear can cause panic, revenge, inability to take action, or a host of other emotional reactions which will be detrimental to your trading account.

Like the futures exchanges implement Daily Price Limits to control irrational exuberance, you, as an individual trader, must devise your own Daily Max Loss Limit rules to contain self-inflicted irrational exuberance.

You will find the next trading day awaits you with money still in your trading account; and the possibility to find better trades and move forward in your trading career.

Otherwise, if you don't have these rules, you run the chance of not having money to trade with the next trading session. Of course, the bright side is that you will have a tremendous tax loss for the year if you lose all of your trading capital, but I don't think most traders want that.

For more information on the mental side of trading, you can read an article I wrote for Barchart entitled "Three Limiting Factors That May Affect Your Trading Prosperity." 

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