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Understand Your Risk Tolerance To Improve Your Trade Management

Our subconscious mind is far more powerful than our conscious mind. And this can work against us when it comes to risking our money to make more money. Our subconscious mind makes all the big decisions, such as breathing, waking, and sleeping, while the conscious mind is occupied with where to eat, how to dress, and what to talk to other people about. The conscious mind is your free spirit while the subconscious mind is your internal authoritative figure. While you consciously may consider buying a new sports utility vehicle to surprise your family and impress your friends, your subconscious mind decides you better check with your spouse first. Your subconscious is rarely impulsive, unless it has to protect you. Your conscious on the other is generally quite impulsive. In trading it is almost always you're conscious mind that gets you into trades, and your subconscious mind that exits them. If you do not know what you are doing in trading, your subconscious is a good thing, because it protects you from losing more money. If you have a sound trading method however, your subconscious can get in the way, because it will have you exiting trades on normal draw-downs, right before the market moves in your direction. We call these phenomena Risk Tolerance Threshold Theory, and are confident that it will help in your own trade selection.

Risk Tolerance Threshold Theory, Tenet 3: "The price level at which individual traders exit, or reverse, their position is their personal tolerance threshold. Everyone who enters an investment or trade has a mental point where they will exit to cut the loss. For most of us that point is going to be less than we initially think - without prior training and experience we are generally not as bold as we think when it comes to money. And statistically that capitulation point is going to be at the worst time -- just before the market reverts back to its dominant slope. In hindsight exiting was a bad idea, which is what happens when we make decisions regarding money while under stress. In other words, unless we understand this human tendency of consciously underestimating our ability to sustain loss, and take steps to turn that weakness into strength when it comes to risking our money to make more money, we are programmed to fail".

(click to enlarge)Click to enlarge
Figure 1.

What is even more fascinating about the theory is the price levels seen from the collective average of trader's exiting prematurely, as represented by the height or depth of a market's counter-trend retracements. This behavior demonstrates how those retracements very often mimic growth curves in nature, i.e.: Fibonacci levels, and tend to repeat themselves. The 4-hour chart of USDJPY in Figure 1 over the past 6-weeks demonstrates this tendency. Not only are traders exiting at those predictable levels but they are doing it repeatedly. Also see how there are different retracements on different time frame patterns. For example a 1-week pattern may retrace beyond a .618 retracement leaving short-term traders to believe a reversal is in the making, only to have the .618 on the 2-week or 3-week pattern hold. Like behavior (repetition) on different scales - time frames - is a hallmark of fractal geometry and is another confirmation for us that markets are fractal in nature.

The solution for traders is simple: find a market with an obvious slope or pattern, wait for a counter-trend move where the majority of untrained traders exit or reverse their positions at those predictable levels out of subconscious fear, and get onboard as price is shifting back in-line with the predominant slope - plenty of examples of this in the chart above. It is easier said than done however. Another tendency of our conscious mind is it wants to contribute to how it thinks things should be, rather than accept how they are and go with the flow.

Jay Norris is the author of The Secret to Trading Forex, Futures, and ETF's: Risk Tolerance Threshold Theory

To see Jay highlight trade set-ups and signals in live markets go to: Live Market Analysis