Trading Risk Management - Rule of Three

By Lance Beggs

Would you like to discover a quick and simple risk management
strategy that is easy to apply to any trading plan, and has the
potential to vastly improve results? Excellent!

I’m not talking about the placement of stop losses, which is
what most people consider as ‘risk management’. Rather, this is
a simple tool for managing the risk in your trading business.

Effective trading requires focus and discipline. There are many
external factors that can interrupt your focus, and destroy your
discipline, such as:

- An unreliable internet connection
- Your charting platform losing its signal
- A knock at the door
- The telephone ringing
- A baby crying
- Hunger
- Noticeably too hot or cold
- Fatigue (hopefully from late night trading study, rather than
alcohol and party induced fatigue)

And as if that’s not enough, there are many internal factors
that can also interrupt your focus, and destroy your discipline,
leading you to make decisions and actions based on emotion,
rather than following your documented trading plan. You’ve no
doubt experienced some of these already. The internal factors
would include things such as:

- Hesitation in entering once price triggers an entry
- Hesitation in exiting when price hits your stop loss
- Doubt about your entry after entering the trade
- Fear of exiting at your stop loss
- Worry about how you will explain another loss to your partner

- Any thought about an early exit of this trade, just to make
up for earlier losses

There’s a whole lot more, but hopefully you get the point.

One flaw in many trading plans is the absence of a valid
strategy for managing these risks. So, let’s fix that situation.


The problem is, traders have no guidelines as to:

- When the risk justifies us stopping our trading,
- When to just pause trading and manage the issue, or
- When to ignore it and continue trading.

The way I do this is using a very simple risk management
strategy developed by Shell, a global group of energy and
petrochemical companies. Obviously they didn’t create it for use
in trading – I just find that it works really well in this
environment. (Yes, I know what you’re thinking - I am a risk
management nerd!)

What we need to do is firstly classify your current trading as
being in a GREEN, AMBER or RED condition. Think of a set of
traffic lights. GREEN indicates that everything is fine. This is
the desired trading environment. RED is a compulsory STOP
condition. And AMBER is a warning that you need to be prepared
to stop.

What I’d like you to consider is documenting any RED conditions
within your trading plan. This might include things like:

- An unreliable internet connection
- Your charting platform losing it’s signal (when you have no
alternative)
- Fatigue due to less than six hours sleep the night before, or
more than four consecutive nights with less than eight hours
sleep (customise this for your own requirements)

These are mandatory STOP trading criteria. Alongside each of
these risks you need to define the actions you will take. For
example, how will you manage your charting platform going down?
If you’re a long term trader this might not cause too much
stress and may actually be an AMBER rather than RED – your stops
may be in the market and you probably have alternative charting
options. However if you’re a day-trader operating on small
timeframes, this is clearly a RED criteria. You may choose to
manage this by contacting your broker by phone and closing out
all positions.

So, for each risk we define as a RED, we simply document a
procedure to manage that situation. And when one of these
conditions emerges while trading, we carry out our procedure,
and then stop trading until the condition has gone.

Now, everything else that is not as serious as a RED, but can
still influence our trading, is an AMBER. The problem here is,
as mentioned before, when does it justify stopping, or when
should we just continue with our trading?

The Rule of Three risk management strategy simply states that
if you get three or more AMBER conditions then that is also an
automatic stop. At that point you can either quit for the day
and head for the golf course, or manage your AMBERs back to
GREEN and resume trading.

So, if your baby is teething, and just won’t stop crying
despite your partners attempts to comfort her, and you just
suffered your second loss in a row, and you now find yourself
hesitating at an entry trigger – that’s three AMBERs.

STOP TRADING!

Before you continue, make sure you manage your risk back into
GREEN, or at least less than three AMBERs. Perhaps take a short
break to review your two losses and confirm that the setups were
valid, review your trading statistics to confirm that two losses
in a row is a normal occurrence, and conduct a short relaxation
and visualization session. If you’re braver than I am you might
also ask your partner to take the baby out for a drive (ask
nicely though!)

If you’re satisfied that you’ve now managed the situation back
to less than three AMBERs, or ideally completely back to GREEN,
then you’re right to start trading again. Otherwise, take the
day off. Sometimes a ‘three AMBER’ complete break from trading
is a wise move.

While we all hope that our trading will occur within a
completely GREEN environment, life’s just not like that. The
Rule of Three risk management strategy gives you a simple
guideline for when enough is enough – and you need to either
stop completely, or reduce some of the external or internal
risks. Try it, and see if it helps in your trading as much as it
does in mine.

It’s simple:

- GREEN is GO,
- AMBER is CAUTION and
- RED is STOP, but
- 3 AMBERs are equivalent to a RED. Stop trading, or manage
those AMBERs back to GREEN.

Happy (hopefully GREEN) trading,

Lance Beggs

© Copyright 2008. Lance Beggs. All Rights Reserved.

About the Author: Would you like to learn more about how I
trade the forex and equity index markets? Check out the
articles, videos and trading resources on my website right now
at http://www.YourTradingCoach.com .

Source: http://www.isnare.com

Permanent Link: http://www.isnare.com/?aid=297164&ca=Finances