What Are the Greatest Risks in Trading Coming From the Market Itself?
Markets are chaotic and dangerous playing fields. There are an infinite number of dangers and risks involved with trading and investing. Are you protected against them all?
In previous articles, we’ve covered the importance of managing risk and went through some general risks associated with trading crypto. Now we’ve come to talking about risks that are the direct result of playing in the markets. Let's delve in.
Markets are always unpredictable and, for the most part, completely random ecosystems of buyers, sellers, and enablers (exchanges, market makers…).
The price may sometimes trend, the charts may repeat certain fractals and patterns, and trading systems and algorithms may work pretty well sometimes, but never always! That’s important. Very important. Nothing works always.
Why is that so important to understand?
Because even if you have the best system, the best edge in the market, the best algorithm, or are simply a genius trader who can do no wrong, there will come a time when that is not the case.
Every system, no matter how high its win rate, will have to go through losses.
Every edge in the market will come upon a situation where it simply doesn’t work.
Every algorithm will be met with market conditions it wasn’t programmed to handle.
And every trader will be wrong on his trades, at least from time to time.
For a realistic illustration, the best traders in history have self-proclaimed to have between 40% and 60% win rates on their trades.
Whaaaaat? Yes. And that is more than good enough if you lose small when you’re wrong and win big (ish) when you win. Trend-following traders are known for being on the extreme side of this equation. Dozens of failed attempts and then one or two huge winners held for a long period of time. Below are a few examples of such trading.
In the next image, you can see what is the required win rate if your trading strategy has one of the following win-to-loss ratios (how much you win vs. how much you lose on average). Keep in mind, though, that you only directly control how much you lose on each trade, not how much you win!
You know what? I believe you! You are the best trader that ever lived in the history of this world. But even with a 95% win rate on your trading (heck, even 99%), that doesn’t make a speck of difference.
If you don’t have good risk management systems in place, if you don’t protect your money first, you will lose it all!
It’s just a matter of time. Below are two random examples illustrating this point.
I belonged in that right column once upon a time. My winning streak was epic. I felt infallible. At the time, I was trading one of those “balls out, all in, buy every panic” strategies in a bull market that work great until they don’t. And then they take it all!
Not convinced? It can’t happen to you? Let's test this on an example.
You start trading with 1,000 USD, and with your 100% winning streak, you turn it into 100,000 USD in just a year. You simply cannot miss. Every trade is a winner. Your hands are golden. You must be a direct descendant of the old gods of fame and fortune, pissing gold and pooping miracles at the same time. You will be the best trader in the known world and beyond. There is nothing that can stop you from turning this 100,000 USD into 100 million USD.
You are so sure of yourself that you always play the whole stack. Why hold back when you never lose? It’s just going to take longer to get to 100 million, right?
In the background, you can hear your family and friends pleading you to take some money out of the account. “Pay off your debts, set up some money aside, diversify.”
You hear them. You know they mean well, but you wave it off. They just don’t understand! “If I take half the money out, I’ve got half less to work with, and it’s going to take twice as long to become a millionaire,” you calculate. “To hell with that. I’m just getting started. I’m on a roll. “
And perhaps you continue to keep booking one win after another for a while still. Maybe you manage to run it up to a million. “Sell half, buy a house, for crying out loud,” your father screams at dinner.
“Dad, I know what I’m doing, don’t worry. I’ll be able to buy 10 houses soon. I’m not taking anything out”, you confidently reply.
And then one day, another simple trade, one you’ve taken a hundred times before. Nothing special about it. Everything looks great. You enter, and the price goes against you a little. Great, you think, an even better entry and you buy more. The next day you wake up, and the price is now down quite a lot from your last entry. You’re a little surprised, but that’s nothing. You’ve been here before. You can’t say no to such a great discount, and you buy more. You stare at the screen, but there’s no bounce. No green candles are to be seen anywhere.
“Maybe it’ll just take a little longer,” you say to yourself and put on a movie to quiet your mind. Another day, another low. Your average entry is now 20% above the current price. You don’t like that. But hey, this will be the one I make it big with, you decide, and you buy everything you can with the rest of your stack. Chances like this don't come along all that often, after all! Besides, we’re down like 75% in a few days. This thing can’t possibly go any lower. Perhaps you even scream: “I am the bottom!” when you click the buy button.
The price stalls for a day or two, affirming your thesis for the bottom being in. But the very next day, you notice that there is suspiciously little liquidity in the market. Hmm, odd, but you don’t concern yourself too much. Another day, another low. You’re now heavily underwater, and it’s starting to hurt. You get a little worried, but not too much. Because you just know that this trade always works itself out in the end. The rest is just noise.
A week or two later, no change. You’re still down. Down a lot. You notice that the rest of the market has shown some signs of life, only your chosen instrument (coin, stock…) is in the red. You start scouring the internet for clues. Perhaps something bad happened that you weren’t aware of? Fuck! Something did happen. And it doesn’t look good. Everybody else seems to have cashed out by now. You don’t like that thought and cover it with the idea that, by now, there is no one left to sell. So there is only one way left to go - up.
After a few weeks, you start doubting yourself. What if this thing really doesn’t go back up? You know what you should do - dump it all and save what you can, but you cannot bring yourself to do it. The loss has now grown too large. The thought of losing that much money is incomprehensible to you. You would lose more than half of everything. “Unacceptable! I’ll wait, at least for a larger bounce. There’s always a bounce, always! A cat somewhere will be sacrificed, and a bounce will be had,” you comfort yourself.
I might be willing to take a smaller loss, like 20%, you decide. We’ll see how I feel when I get there. A few more days or weeks of constant slipping lower and lower. You can hardly breathe, it’s like an elephant has set on your chest and simply won't get off, the fat bastard. You’re stuck in this trade and even though there is some positive activity in the market, trades to be played, your funds are all tied up. All you can do is sit and wait. Pray and hope for salvation.
Maybe you do get a little bounce, perhaps even a 20% green candle. In that euphoria, you forget what you decided about taking a loss. “Fuck that! Why take a loss when I can still turn this around? Breakeven sounds better. Then I can just pretend it didn’t happen. I’ll see how it looks when I get there.” you say to yourself.
But the rally is short-lived. The price was nowhere near your breakeven point. You didn’t take the smaller loss, and now you’re in an even worse position than you were before.
Days go by, and nothing happens. You notice some even more terrible news about your open position. Now you’re down 90%. There is no point selling things now. You’re depressed. You’ve given up. “If it gets back up, it does. If it doesn't, I’m going down with this ship,” you decide.
A few months pass. If you’ve got an old vice to which you turn to in dark times, you’re now knee-deep in it. Alcohol, smoking, drugs, sex, games… whatever it is. You live there now. Reality is too hard to bear. “If I don’t sell, it didn’t happen!”
Trust me, dear reader, I know. I’ve been there. I’ve felt the pain. I know what it feels like when you are physically sick just thinking about your position. When you can’t make yourself move the mouse cursor over the “close” button because the pain of such a large loss is unimaginable. When your whole world is crumbling down, all your plans are gone. All that money is gone. And at this moment, there is nothing you can do about it anymore. What’s done is done. But you still cling to some silly hope, more a miracle than anything else by now. “How could this have happened to me? It wasn't supposed to happen this way. This system always worked. Why is this happening to me? Why?!”
One bad trade, left unprotected, can wipe out years of success! Just one bad trade. One bad decision. One freak occurrence in the market. One fucking black swan event that was never supposed to happen. Everything you’ve worked so hard for is simply gone.
I hope I’ve now demonstrated how easily one can get trapped in such a scenario. It has happened to most of us at one point or another until we learned that all-important lesson:
Trading is predominantly managing risk and only secondarily seeking profit.
Warren Buffett has said that his two most important rules are:
Never lose money!
Never forget rule number one!
All of my more significant losses in the markets were down to one single mistake. Not managing risk properly. Either not cutting the trade when I knew I should have or putting too large a position on in the first place.
In spot trading, the losses and associated pain were rather contained and dragged out.
In leveraged trading, the lessons came much faster and in a much more brutal fashion. Think - losing everything in an hour, not days or weeks!
So what are some of the most important lessons I’ve learned about risks posed by the market itself?
First and foremost, markets can and will do whatever they want, and there is nothing you or I can do about it.
Markets can stay irrational longer than you can stay solvent. You really shouldn’t go against the market.
The market is always right. No matter how unintuitive or plain wrong it seems at the moment or how good your thesis is.
Prices in a bull market can go a lot higher than anyone expects, and in bear markets, a lot lower for a longer period of time than one expects.
Trying to guess tops or bottoms tends to be a fairly costly and problematic affair, even though it is a tempting one. Your EGO might demand it.
No one can predict the market with any substantial degree of certainty, like we’ve already talked about. No, not even your favorite influencer, trader, investor, or giant giga-brain individual. Predictions, while fun, are of no real use in trading or investing.
Anything can happen in the markets at any time.
You really should take this quite literally, especially in the crypto markets. One small piece of news, one hack, one delisting or listing, one influencer shoutout, one FED decision, one fork, one country's bureaucratic decree, and everything changes in a second. The most wanted stock or coin can become completely worthless at any moment in time. Of course, the smaller the instrument, the bigger the chances of something like that happening.
Even if the odds of something happening are infinitesimal, the threat is still real.
We all know, for instance, that our beloved Bitcoin can still go to zero. Zero, zero. It’s not very likely. In fact, I would say that with every surviving year or incident, the chances for that are getting smaller and smaller. But they are not zero!
Any crypto exchange can, for example, close its doors overnight, leaving you penniless without any warning. The biggest ones have a much smaller chance or incentive of pushing themselves into that particular corner, but every once in a while, some still do (Mt. Gox, FTX…). If something is at all possible, it can happen at any time.
The so-called black swan event is a real thing!
And no, you can’t predict it, or else it’s not really a black swan event, is it? Situations that come out of the blue that no one saw coming. Like a worldwide pandemic. Wars can happen overnight. Significant events that surprise more or less everyone do happen from time to time.
And the only way to be protected from them is with absolute risk management, which is independent of any particular event or situation. As an example, if you only have 10% of your whole portfolio in Bitcoin and on a trading platform, 90% of your money is guarded against anything that might happen to either Bitcoin or the exchange. Even the worst-case scenario options.
Every moment in the market is unique.
No matter how often a certain price action chart pattern or cycle successfully repeats, there is absolutely no guarantee that it will happen this time. There is no correlation. None. Zero. The reason most of them work anyway is because traders and people involved in the markets expect them to. A self-fulfilling prophecy. But the fact is that we can never know what all of the market participants know, think, or how they will react.
Just because something worked once, twice, or ten times, it doesn’t mean it will work the next time. And vice versa. Just because we may have had five losing trades in a row with our system, no one can know for certain if the next one will work out or not. That’s why in trading, we talk about evaluating probabilities, risk-reward ratios, and managing risk.
Things aren't always what they seem.
There are many players in the market, some of them with really deep pockets that may have developed some, let’s call them “creative” solutions to the problem of liquidity in moving large money around. In order for them to successfully trade certain instruments, they have to play sort of mind games with the other market participants. Like Orca, killer whales, they coordinate between themselves and herd their prey into desired killing fields.
In the charts, that creates a lot of fake breakouts through support/resistance lines or obvious patterns that traders are watching, where “the ominous they” herd together buyers or sellers into so-called liquidity pools, thereby using them as entry or exit liquidity, without leaving a visible mark on the market. They stay invisible in the order books and avoid moving the price too much, taking on additional slippage. Large players can also paint the charts and order books in order to move the price. Liquidity is a fairly problematic area in the cryptocurrency markets, and so these fake moves tend to be quite dominant and easily recognizable in the charts.
So now that we understand that we must always protect ourselves from the market, we must also mention the biggest enemy of every trader. Himself!
As a trader, you will be embarking on a journey of self-discovery.
But it won’t be any old touchy-feely therapist kind of getting to know oneself. These are hardcore, bloody, violent realizations with substantial real-life consequences. If this is something that scares you, stay as far away from trading as possible. This is a brutal game, and it will push you mentally and physically beyond what you thought you could handle. I know of no better or harsher teacher than the market.
The rewards promised are great, freedom and the uncapped possibility of wealth, but the dangers are even more impactful.
Many a trader has ended his life when he couldn’t handle the market and its darker sides.
Many have fallen into alcohol and drugs.
For a lot of the traders out there, trading became an obsession, an addiction they needed rehab from.
Trading or investing needn’t be that stressful, but it does take a while to get to that point. Most give up before they ever reach that level before they learn the right lessons and build the proper trader mentality. Which one are you?
In the next post of the series, we will be focusing on “trade execution risks,” so subscribe and follow along.
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