Chapter 10 Risk Control and Discipline: Keys to success (from Stanley Kroll's Dragons and Bulls)

In the jungle, for all creatures large and small, the first priority is survival. This should apply to financial speculators, as well. Here however, 'survival' is translated as 'risk control' and 'discipline.' The quest for profits is important, but even this basic drive takes second place to the dual imperatives of risk control and discipline. The Scots have an old saying, 'Mind your pennies and the pounds will take care of themselves.' The corollary to this in financial speculation is, 'Mind your losses and the profits will take care of themselves.'

There are a number of excellent books which describe the strategies and techniques of the leading portfolio investors of our time. These are fascinating accounts of a diverse group of talented men and women, whose investment feats have made them highly acclaimed experts throughout the various sectors of investments. Studying these accounts, one is struck by the wide ranging expertise of these 'money masters' and 'marker wizards': stock speculation, long-term value investing, short-term scalping, options strategies and currency or bond trading. In fact, just about every one of these experts plies his or her personal operations quite differently from the others. There is hardly a single common element in their professional activities; with one exception. Each one of them acknowledges that risk control and discipline are clearly the two most significant aspects of their overall success. The single element on which they all agree. Clearly, for every investor who reads this book, regardless of the field of investment he or she focuses on, the most important tactic for consistent and successful speculation is to control losses, also known as risk control, and discipline to 'trade by the rules.' If you can control losses and allow profits to run, and that is not easy to accomplish, you can be a consistent winner. What should be sought is a systematic, objective approach to risk control and discipline, which would include

the following three areas:

1. Limit Your Risk on Each Position

(a)

One approach is to establish a maximum loss limit on each market, to say, 1% to 3% of your capital, the precise amount depending on the size of the account. For smaller accounts, it

might not be practical to try to limit losses to 1%, as your stops would be so tight as to result in a string of losses due to whipsaw moves. There's nothing magic about this specific technique; it just helps enforce a discipline to control losses in an objective and systematic manner.

(b)

Another approach is to equate risk on each position to the respective exchange minimum margin and to limit risk to a percentage of such margin. Equating acceptable risk to a percentage of margin is a logical strategy, especially in futures trading, where margins are set by each exchange and are generally related to the volatility, and indirectly, to the risk or profit potential of each market. For example, on the Chicago Board of Trade, the world's principal grain futures exchange, the margin on a 5,000 bushel contract of corn is US$400, while the margin on a 5,000 bushel contract of soybeans, considered a more volatile and high-flying market, is US$800. If, for example, your risk is limited to 70% of margin, you would risk US$560 on soybeans versus US$280 on corn because your profit potential would be higher on soybeans than on corn.

(c)

Stock traders can limit speculative trading risks based on the value of the investment, but the precise amount would depend on lite volatility of the stock, with a more volatile stock

requiring somewhat looser stops. Such loss limits could be between 15% to 20% of the investment. Thus a trade in a US$30.00 stock could be stopped to limit losses to US$4.50 to US$6.00.

(d)

Also, one should not use more than one third of the capital in a speculative trading account to margin positions, keeping two thirds in reserve, to be held at interest, as a cushion. If the account equity declines, you should seek to reduce positions, so as to retain this recommended one third ratio.

2 Avoid Over trading

This admonition pertains to both excessive trading activity, such as churning, and to putting on too large a position in relation to the capital in an account. You aren't likely to trade successfully if you are over trading, or if you are excessively focused on short-term scalping, or if the first adverse swing will have you responding to a margin call.

3. Cut Your Losses

Any time you enter a speculative, trading position, you should clearly know where your bail out point (stop loss) will be and you should enter the stop with your broker. Experienced traders who sit in front of an online monitor and who have the discipline to dump a position

when and if it reaches their bail out point, may not actually want to put the stop to the floor, especially if they are holding a substantial position, as it could be a magnet to attract floor traders' attention to hitting the stop. The key aspect here is discipline, because not entering the stop should never be used as an excuse for overstaying a market, or for rationalizing any delay in liquidating at the designated stop point. Assuming a newly entered position starts to move against you from the outset, the stop, if entered correctly, should get you out with just a

reasonable loss. However, what should you do about stop protection if the market starts to move favourably, putting paper profits in your account? Clearly, you will want to adopt some strategy to advance the stop so that a good paper profit doesn't turn into a big loss if the market reverses. Here, the maxim to focus on is, 'never allow :1 good profit to

turn into a loss.' But, how exactly should this be handled? One recommended strategy is to advance your stop (if long, raise the stop;

if short, lower the stop) after each Friday's close, by an amount equal to 50% of the week's favourable move. For example, if you are short gold and the market declines by US$10.00 during one week, you would lower your buy stop by US$5.00 as of Friday's close. However,

if a market moves against you on any week, you should leave the previous week's stop intact. Eventually, the market will reverse and stop you out; but if you have enjoyed a good run, you will have advanced into a no-loss stop position and, ultimately, a profitable one.