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Hirschhorn: On Days Like Today, It's All About Risk-Reward

Days like today make traders wish they had flattened up and taken a seat on the bench rather than play and watch their year-long returns evaporate in hours.

New York Stock Exchange
Photo: Oliver Quillia for CNBC.co
New York Stock Exchange

Months to build up, enduring pain, fighting to stay in the game (or get positive) and then, the markets fall apart. Is QE2 to blame? European credit concerns? China's potential rate hikes? No one really knows for sure the cause, which makes trading around it all that much more challenging.

If you are stuck, wondering if you should add, hold or liquidate, as an investment psychology advisor, I have a process you can use to help you come to a definitive conclusion about which strategy is best in any given situation.

You need to think in terms or "risk-reward."

Now, normally I would tell my clients to ask themselves, "If I had no position on right now, what would I do?" That question forces them to think objectively about their trades. But as we approach year-end it is a bit different and how you manage your risk should change. Like it or not, each trade made later in the year means more than it did earlier in the year.

If the score is zero, zero and your goalie saves 50 shots throughout the game but dives (when he shouldn't have) to save that one last shot and misses it in the final seconds - then the only save that mattered was the one he failed to make because he dove for it. Game over, you lose. That sucks but it is the truth.

Trading these markets is precisely the same. You have to weigh the risk-reward of the situation and decide if it is better to dive for it or to stay on your feet.

If you miss it now, it can define your whole season. I am not saying you should automatically play it safe right now but I am saying we are in the late stages of a long and painful season and sometimes the financial and psychological risk of losing outweighs the rewards of winning. And no matter what, the most important goal you should keep in mind is to be in a position to play the game when the next season in 2011 comes around because great trading is a marathon, not a sprint.

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Doug Hirschhorn is the chief executive officer of Edge Consulting, a firm specializing in “Peak Performance Coaching.” He holds a Ph.D. in Psychology with a specialization in sport psychology, and has offices in New York and South Florida. His client list includes elite athletes as well as many of the largest banks, hedge funds and financial institutions in the world. Doug is presently at work on his new book, Street Smarts (Putnam, 2010).

Have a question for Doug? You can reach him through his Web site, DrDoug.com

Disclaimer: Doug Hirschhorn's expertise is in the psychology of achieving peak performance. He is not a financial advisor and does not make trading or investment recommendations or provide trading or investment advice. He is an expert on the mental game. Although Doug Hirschhorn has a Ph.D. in Psychology with a specialization in sport psychology, he is not a licensed psychologist and does not provide therapeutic, clinical or counseling services.