“The first rule of investing is not to lose money; the second rule is not to forget the first rule.”
-Warren Buffet, Legendary Investor
The reason I love the above quote is that it speaks to heart of successful trading, which is risk management.
As we've discussed before in Trader's Classroom, knowing when you're right is relatively easy to discern. However, knowing when you're wrong...not so much. This is why the Wave Principle is such a valuable discipline. The rules and guidelines it provides allows you the ability to know when to change your mind or reevaluate your trade plan.
The concept of confirming price action is equally important when it comes to risk management. Waiting for confirmation slows your trading down and allows you to focus your attention on positions that have proven themselves. Put simply, let the market commit to you before you commit to the market.
As an analyst or trader, you're not always going to be right — this is a fact. However, you can maximize your profits and mitigate your losses by employing the habits of successful professional traders — don't pick tops or bottoms, know when you're wrong, follow your money management rules, etc.
Lastly, were going to look at risk and where a trade has gone wrong?
It may help you to know up front that the absolute cleanest patterns you’ll ever see often do not work out. The reason they do not work out has less to do with the price pattern and more to do with the subsequent patterns we discussed in the selection component. Where many traders, including myself, have to fight the mental giant of greed is when you recognize a clean pattern, enter a trade based on that pattern, and then when the price starts to move against your expectation you hold on believing that the pattern will eventually play itself out. Of course, the market does not have to do anything and sometimes failed patterns provide stronger moves against the anticipated direction of the pattern so that fighting the new move on a failed pattern becomes very costly.
A helpful mental tip is to recognize how high the stakes become for failure when you hold a losing trade. High stakes effectively means that your risk of run increases significantly when you either over leverage or light a losing trade take more from you then you should allow any trade to take from you.
Patterns are a probability based approach. Probability means that we’re hoping for an edge at best but we’re not guaranteed anything. For many traders, this probability based approach is a favorable concept but much more difficult in practice. The difficulty comes in real-time because you have no idea at the moment if you’re in the midst of a hit or a miss. Unfortunately, a trader must have a steel nerve as to getting out of a trade as soon as the edge or price action level is invalidated. The invalidated view must take you out of the trade because if not, you’re topping over your entire trading system.
Most trading systems are based on a delicate balance of risk: reward. The risk part of the trading system must be guarded for all its worth. When that balance turns over and a trader takes a large loss then a trader finds themselves in a very difficult predicament. The initial impulse is often to try and bag a big winner that will overcome the recent loss.
Unfortunately, this can come at the worst possible time. A trader should be fighting to align with their profit: ratio as soon as possible. However, if they try and fill in the gapping profit whole with a big win, they open themselves up to throwing their whole system. In short, the stakes are high if you let your risk: reward slip. As a trader, it should be your biggest fight.