Some Prevalent Misconceptions
You will come face to face with many prevalent misconceptions in this text. Among these are:
• Potential gain to potential risk is a straight-line function. That is, the more you risk, the more you stand to gain.
• Where you are on the spectrum of risk depends on the type of vehicle you are trading in.
• Diversification reduces drawdowns (it can do this, but only to a very minor extent-much less than most traders realize).
• Price behaves in a rational manner.
The last of these misconceptions, that price behaves in a rational manner, is probably the least understood of all, considering how devastating its effects can be. By "rational manner" is meant that when a trade occurs at a certain price, you can be certain that pricewill proceed in an orderly fashion to the next tick, whether up or down-that is, if a price is making a move from one point to the next, it will trade at every point in between. Most people are vaguely aware that price does not behave this way, yet most people develop trading methodologies that assume that price does act in this orderly fashion.
But price is a synthetic perceived value, and therefore does not act in such a rational manner. Price can make very large leaps at times when proceeding from one price to the next, completely bypassing all prices in between. Price is capable of making gigantic leaps, and far more frequently than most traders believe. To be on the wrong side of such a move can be a devastating experience, completely wiping out a trader.
Why bring up this point here? Because the foundation of any effective gaming strategy (and money management is, in the final analysis, a gaming strategy) is to hope for the best but prepare for the worst.
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