July 2001

Talking about disaster isn't a popular pastime. No one starts trading even consciously thinking about it, but it should be your constant worry, even as you become an experienced trader.

In a famous Zen fable, a novice swordsman experiences what is akin to a trader's initiation into his art. In the story, to teach him patience, the novice swordsman was set to work cooking, carrying water, and cleaning. He was never allowed to mention swordsmanship nor was he allowed to practice or train in any manner. After three years of this, he began to despair of ever becoming a master swordsman. Then one day, as he cooked, his master sprang around the corner of a building and delivered a blow to his back with a wooden sword -- then scampered away. The next day, as the novice cleaned, the master struck again, in much the same way.

From that time on, the novice was never without fear. Day and night, he had to protect himself, without a sword, from his masterís assaults. He learned the hard way, that alertness is the prelude to successful offense.

Similarly, in war itself, you are never without fear -- it's as though a cocked pistol is always aimed at your head, ready to go off. A stray round could get you at any time, in any place. You learn to be alert, even in your sleep, before launching your own forays. And so it is in trading. You could blow off the danger, but instead, you should be alert. You should explore what gives rise to your justifiable fear. Explore where the danger most likely comes from, how big the danger is, what warnings it gives. Know your enemy and stand watch.

To help you out, Tushar Chande has come up with some interesting information on the size of your enemy in "Estimating Future Drawdowns" (page 28). It turns out that reasonably reliable estimates of how big a disaster you face can be derived from the monthly volatility of trading managers. Check the article out and hope that he extends his work to, say, trading systems. Both his technique and his findings deserve extension.

You can't "manage" fear. You can manage the terms of engagement, though, and that's what Wolf von Ronik addresses in "Your Crash Potential" on page 20. The best rule for avoiding disaster, even those measured by Chande, is to keep your commitment under control. Still, since I never stop hearing about those overcommitted to a particular position, I couldn't resist an issue focusing on avoiding disaster. If nothing else, it will encourage traders to keep their guard up.

Finally, an understanding of basic probabilities is essential for any trader. Just as good card players know and use the probabilities to estimate their chances, so should traders use such knowledge in their trading. And even before estimating their chances in a trade, far too few traders understand the iron laws of money management that von Ronik introduces. Yet these basics affect far more than traders suspect; they get right to whether you finish the game, let alone make money at it. First things first -- survive, then thrive.

- Good Fortune!

John Sweeney, Technical Editor

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