If you ever happen to run into a mountain lion while hiking, you should know that the best thing to do is not to run. What you should do is stand up as tall as you can and open up your coat or jacket to make yourself look larger. This technique actually works well against polar bears also. This is an example of the worst case scenario when you are hiking or ice skating in the North Pole. What about the worst case scenario when trading? Have you ever considered it?

Do you remember the story of Long Term Capital Management? Well this Shakespearean tragedy, occurred four years after it was founded by several geniuses including John Meriwether, Myron Scholes, and Robert Merton. Does the name Scholes sound familiar to you? His name is the one in the Black Scholes option pricing model. These gentleman started a hedge fund and were doing quite well until 1998 when they lost over 4 billion dollars and nearly caused a stock market crash. They were making money from the concept of reversion to mean which means that when volatility increased above historical norms, they profited from the volatility decreases back to the historical average. There were several problems with their methods though. For one thing, they did not consider carefully enough what the worst case scenarios were. The other problem was that although LTCM invested in many different assets, virtually all of them were betting on reversions to the mean (they were all betting on the same phenomenon). Finally, the top traders at LTCM were so blindly confident that they made disproportionately large bets that led to their demise.

If Nobel-prize-winning geniuses can be blind to risks and worse case scenarios, is it possible that you could be the same? So, what are the main mistakes that traders make when they develop trading systems? One problem is that traders donââ,¬â"¢t worry enough. Their main concern is making profitable systems. Most traders have to sell their systems to someone, including themselves. So, they have a knack of being overly enthusiastic and eventually, overconfident. This can lead to seeking the most profitable system with little consideration about risks. Another mistake that is commonly made is that traders look at the disasters that other traders make and think to themselves, "it could never happen to me, because I know better." Let's be realistic here. Human behavioral patterns are very repetitive. There have been booms, busts, miracles, and breakthroughs of the same kind since the beginning of time, and there always will be because people are people. Keep in mind, that you can make mistakes. Write down your possible mistakes, and avoid them.

So what should we do to manage risk? First of all, we must develop systems in this unique way: make a list of at least five different things that could go wrong in implementation of your trading or market conditions. For example, in doing so, LTCM may have realized that a potential problem that could go wrong is the possibility of a unique period when prices move much more than expected and did not revert back to the mean for a much longer time than expected. Could the fund survive? Or, perhaps LTCM should have asked, "what would happen if we took positions that were too large and we lost on them?" Or, "What if we start out with tremendous success and then blindly expect the strategy to work exactly the same indefinitely?" Although these questions seem pessimistic, the responsible, effective trader should ask these questions with regularity.

Let's sum it up then:

• When developing systems ask what the worst case scenario and try to estimate the probability of it actually happening.
• When developing systems, write down 5 things that could go wrong.
• Run through several bad scenarios and try to estimate the probability of each one happening.

These steps will help you survive which is the first goal when trading. Be disciplined and trade well.

Price Headley is the founder and chief analyst of BigTrends.com.