Risk Management

Without adequate risk management, trading success is simply not possible under any circumstances. The main reason for this is mathematics. You can have a good system for entries and exits, but even this potentially profitable system can bankrupt you if you do not practice prudent position sizing. 

The market does not owe you a living, and a losing streak may be more frequent (and longer lasting) than you might expect. It is not at all uncommon to have six, eight, or even ten losing trades in a row while you are working with a good system.  Think about what would happen if you risked 20%, 10%, or even as little as 5% percent of your capital on each of those trades. In the best-case scenario (that of risking only 5% on each trade) you would lose almost half of your trading capital. The worst-case scenario is, of course, that you lose it all!

Professional traders never risk more than 3% of their trading capital on a single trade. As your trading capital reduces, you risk less and less as a proportion of your original trading funds; so your $1000 trading fund diminishes by $30 on the first losing trade and then by a lower $29 on the second losing trade. And so on. This is completely opposite to the natural temptation to place bigger bets on the way down in order to recover the lost ground.

The good news is that is when your trades pay off, your risk capital increases by the same mechanism. If your first winning trade takes your account from $1000 to $1100, you can then afford to risk a higher $33 on your next trade.

This principle is very important, so please take the time to understand it.

If you keep to this simple rule, it will make your trading a relatively worry-free process and you will no longer have any issues with staying in positions that have temporarily gone against you (but not yet reached your stop level).

If you open a position with more than 3% risk, you will likely close the position prematurely out of sheer panic – long before your protective stop order is triggered. Your greed caused you to take a too-big position in the first place, and your fear now causes you to close it prematurely before (as is inevitable) the position you no longer hold turns around.

There is a saying: "Scared money cannot win!"

The only way to make your money "confident" rather than "scared" is to limit the amount of money you choose to risk on a given trade.  Limiting your risk gives you a sense of detachment from a specific trade, so trading becomes more of a statistical process than of an emotional one. Remember that there are old traders and there are bold traders, but there are no old bold traders :)  

As hinted earlier, the majority of novice traders start betting less when they win, and more when they lose. We are hard-wired to make this psychological mistake. After a series of losing trades, we are sure that our luck will change and a winning trade will be just around the corner; so we raise the stakes in order to recover our losses. This strategy is a recipe for disaster, because the next trade can be (and very often is) also a losing trade. The market can go either way at any time, just as an unbiased coin has a 50/50 chance of coming up tails regardless of how many times it has already come up tails.

In order to demonstrate why risk control is often more important than having a system, I would like to tell you about an experiment that has been conducted by researchers in game theory:

Forty Ph.D. students from different disciplines were invited to participate in a trading game.  They were given a hypothetical system which had a guaranteed 60/40 win-to-loss ratio. The participants were given $1000 in trading capital each, and were free to choose the amount they bet on every one of the 100 trades to be made. After 100 “trades” the game was stopped and the results were tallied. The aim of the game was, obviously, to make as much money as possible. 

Imagine the researchers’ surprise when they found that only two  out of forty participants ended up with more than the initial $1000. These were highly educated individuals who were given a system with a guaranteed positive expectancy – 60 trades out of 100 were a guaranteed win! Anyone betting a small fixed amount of money on every trade (let say $10) was guaranteed to come out with a total of $1200 after 100 rounds. Anyone betting according to the 3% rule would make even more; strange, but true.

The trades placed by the 38 ‘losing traders’ were analyzed, and this analysis showed that they increased their bet sizes when suffering losing trades… thereby compounding their losses.

And how interesting is it that the two successful participants represented 5% of the total participants, mirroring the fact that only 5% of financial traders make money in the markets?