Psychology and Risk Management
• What to expect
• Risks
• Position sizing
• illusion of control
• Accepting critisism
• Paralyzed by fear
• Loss is a feedback, not a failure
• The flexible trader
• Focusing on the positive
• Short straddle
• The dynamics of greed
• The herd mentality
• Notes
Security can be found in numbers. Have you ever observed an aquarium’s school of fish? They stick together because a single fish has a lower chance of being caught while swimming in the centre of a pack than when it is swimming alone if a larger fish is nearby and ready to consume one of them. Humans also go to “school” in their daily lives. For instance, it’s simpler to go fast in the middle of a group of automobiles on a deserted route. According to the reasoning, “the highway patrolman can’t pull us all over and give us all tickets.” Sometimes, especially when trading, it’s simpler to go with the flow. As they say,
“The trend is your friend.”
Following the crowd comes naturally to a lot of people. In our favour, it frequently works. Either we should move to the east side and blend in, or we should find out why none of our rich friends live on the west side of town. However, this way of thinking needs to be changed when it comes to trading. Before waiting to follow the mob, you must learn to anticipate what it will do next and to think for yourself. The primary purpose of trading is to make money by buying and selling stocks on the short term. It is challenging to achieve that if you are going with the flow.
Many people find it natural to follow the herd. It often works in our favour. It’s in our best interest to find out why none of our wealthy friends reside on the west side of town, or to just move to the east side and blend in. But when it comes to trading, this way of thinking must be abandoned. You must develop the ability to predict what the mob will do next and learn to act independently before waiting to follow them. The main activity in trading is the short-term purchase and sale of equities for financial gain. If you are going with the flow, it is difficult to do that.
When buying a significant quantity of stock with the intention of selling it when the price rises a few points, you can’t wait for the general public to back up your predictions. Costs fluctuate in cycles. You risk trying to sell as the cycle brings the price back down if you wait too long for the price to hit a peak and for the market to buy a significant number of stock, validating your forecast. And by that time, the purchasing frenzy has passed, and you are probably trying to sell your stock when “fear” has set in and the majority of people are prepared to do so.
Ideally, you should buy stock when the public is going to embark on a buying spree, buy it at a lower price than they will gladly pay, and sell it to them then. You need to be the first person in line prepared to sell when everyone else is waiting in a different queue to buy. You must anticipate the next vogue and behave differently from the majority of people. In terms of realistic strategies, that is more challenging to put into practise.
To foresee the pivot points, for instance, you need precise momentum indicators. But psychologically speaking, one must also be willing to discard the lessons we have received throughout our lives about finding shelter by doing as others do. There is no safety in numbers in this situation. When it comes to trading, you must see the crowd as your rival rather than an ally. You must foresee what they will do and devise a strategy to profit from their anxiety and desire.
Remember that after the California Gold Rush, San Francisco’s mansions were not constructed by mining for rich metals but rather by providing food and other amenities to the large number of inexperienced miners looking to sate their greed. You must equally take advantage of the crowd and profit from their “herd mentality” as a trader. You must be the first to devise a plan to capitalise on their fear and greed to amass your wealth.