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Risk Management. The First Line of Defense. Introduction IV

Parts one, twothree

One of my main
theses is that risk management is the key to long-term success as a
trader.  As such it's a skill that's best developed as early in your trading career as possible.

But that presents a conflict.  If you are brand new to options, you are spending time learning various strategies and trying to understand at least one of them well enough to make trades.  If you accept my premise about the importance of risk management, then becoming familiar with a given strategy is not enough.  Now there's the additional concern of learning to manage risk.

This doesn't have to
be a problem because there is no urgency, especially when you are making trades in a practice, or paper-trading, account.  You must have a good working knowledge of how to trade your strategy before you can get involved with making other trades to 'fix' a troubled position.  When you feel comfortable using your strategy, that's the time to pay attention to discovering what to do when your plan for the trade is not working as hoped.

When you are ready to monitor and adjust a position gone awry, as with any skill, you cannot expect
to be proficient at the start.  The major advantage of trading without real money on the line is that you can experiment with a variety of risk-reducing adjustments.

This may sound overwhelming, and if you feel that way, it's reasonable to exit trades as your only risk management approach – but only as you gain experience and look for alternatives.  the most important aspect of managing trade risk is recognizing that 'doing nothing' is not going to work over the longer-term.

As a new trader, or
as an
experienced trader who is expanding his/her understanding of trading,
please recognize that trading is similar to many other professions.  Practice improves your skill set;  it makes you a better
decision maker.  By making practice trades, you encounter far more decision-making opportunities than when you trade a real account.  In a practice account, you can trade more positions – as long as you are not overwhelmed and devote sufficient time to manage them properly -and that translates into more education, more experience, and greater confidence in your ability to make a good decision under pressure.  Practice is extremely worthwhile.

If you cannot earn
money with a practice account, then there is no reason to believe you
can do any better with real world trading.  Michael Jordan and Tiger
Woods were not born as stars.  They worked long, hard hours and
practiced. A lot.  No one is expecting you to be the top trader, but if
you want to earn a living, it takes work.  You don't just open and
account, enter some trades and collect the cash.

Thus, if I have
encouraged you to learn about risk management, it's okay to get some
good experience with a paper-trading account.  When a trader comes to
believe that proper risk management is vital for long-term success, then
he/she accepts the notion that there is more to learn than merely buying and selling some options.

Not everyone believes in paper trading.  The primary reason is that it's not real and that no emotions are involved in the decision-making process.  In addition, there's a temptation to make it a game.

I cannot disagree more.  First, the successful trader must learn to control emotions, and if you can make emotionless decisions when it's practice money you may be on your way to doing the same with real money.  If you want to be a
winning trader, you must take paper trading seriously.  You must
concentrate on figuring out how to make good decisions, and not just try something weird on
a whim (you an do that in addition to making serious trades).

Paper-trading will be the focus of a future post.

Not everyone has the talent
to become a champion or an expert.  But in the world of trading, you
must be significantly better than average to survive.  I cannot verify
the accuracy of the statement, but I have heard, and find it easy to
believe, that most people who attempt to become traders never
make any money.  If that's true, you must learn, understand, and
practice to be certain you are way above average.



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