4 minute read
Part 9 of 16 excerpted from lesson 12.1 of the upcoming Trade Like a Pro ver. 10 course.
Professionals focus on managing risk, and superior performance is the result. The retail investor focuses on performance, and increased risk is the result. Let us examine the difference between Professional and Retail risk management.
Professionals step into the market knowing they have a proven edge. Because they follow a rule-based process to reduce risk, they get reliable results. The Retail Investor tends to focus on reward potential. They base trades upon current value versus perceived future value.
The Professional’s edge is rule-based as discussed here, here, and here, and creates reliable results. The Retail Investor has either too few or no established criteria for entry. Trades are unique. The only discernible strategy is to buy and hold until they achieve the perceived value.
Rules demand consistent behaviour. Professionals establish a series of steps and the criteria necessary for action. Their process creates continuity from one trade to the next. Consistent actions lead to reliable, predictable results. Breaking the rules produces an unwanted outcome. Repeating a specific process allows probability to work in the Professional’s favour. Each trade may have an uncertain result, but over time the odds favour the Professional with reliable performance.
Profit to Loss Ratio
Professionals measure the risk first and compare it to the potential return. Retail Investors measure the gap between current value and perceived future value then focus on the profit potential in the trade. The risk is often not considered.
The Professional must know the risk to reward ratio. They then determine if the trade is appropriate or not. The Professional will avoid a potential trade if the risk is too great. This can only happen after calculating the risk.
Cost of Trading
Professionals examine the total cost of trading, not just the commissions like Retail Investors. Many institutions need their reporting to be after-tax, after-inflation. Professionals also take into account the slippage or poor execution both of which may occur with a thinly traded security or during times when the VIX is high. Professional traders also account for any extra fees. Professionals avoid illiquid investments for two reasons:
- first, an asset rotation model requires liquidity
- second, the cost of holding illiquid assets when a better opportunity comes along
Retail Investors rarely consider these issues. Professionals know the total cost of a trade to better manage the outcome.
The perspective on profits is the greatest difference between Professionals and Retail. Professionals know that profits are temporary. A retail investor assumes if bought today the market or investment will be more valuable in the future. This Retail philosophy did not work in the decade from 2000-2009. Money invested was worth 3% less at the end of the decade than it was at the beginning.
Professionals are not looking for homeruns. Professionals want to take advantage of the fat middle of a market move. They are able to be paid twice or more to cover the same territory. Professionals understand the truth of Moneyball, that it is more profitable to hit singles than to be a homerun hitter who is also the strikeout king. Professionals take advantage of the opportunities before them and do not hope for some uncertain future.
Professionals know the importance of protecting their capital. For this reason they use stop orders to close a trade when the reason for entering the trade is invalidated. Retail Investors trade their capital without any protection, hoping that a rising tide will keep them profitable. Professionals know that anything can happen, and take measures to protect their capital. They know losses have a greater negative impact than profits have a positive benefit.
Professionals know that the volatility of the markets determine how much they can afford to put at risk at any moment. They size each trade based upon risk. If the VIX increases and the average harmonic of any market increases Professionals know they must reduce the size of their investments to maintain the same risk. Retail Investors trade by lot size or percentage of the portfolio. Both strategies increase their risk in direct proportion to the rise in the VIX. Professionals know the more volatile the market becomes the greater the risk. Therefore, they become more risk averse.
The quickest way for a trader to improve their performance is to change the way they manage risk and make it first priority as Professionals do. This is an excerpt of one lesson from the module on Risk Management that we will discuss during the upcoming Trade Like a Pro course.
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