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Hit the play button for the video, or see below to read the article version.
I had a discussion recently with a trader who lacked an understanding of one of the fundamental principles behind the need for risk and money management. I would hope that all my newsletter subscribers are familiar with this already, but just to be sure, let’s examine this basic concept. I have often said that trading is all about managing risk. When I enter a trade, there’s no way of knowing the outcome I will get. On the up-side, it could be breakeven, it could produce a small profit or (hopefully) it could provide a massive windfall profit. On the down-side, it could produce a small loss. But one thing is certain; when I enter a trade it will NEVER produce a large loss. Why? Because I have learnt the hard way to respect the risk in the markets, and to keep that risk small. I may end up with a large number of breakeven trades, and a large number of small wins and small losses that pretty much cancel each other out. That’s fine, because the large wins result in an overall profitable strategy. Too many newbie traders just don’t get this. You cannot allow yourself ever to suffer a ‘large’ loss. Why? Because it’s harder to recover a loss than it is to make the loss. Huh! How can that be? Please note that I’m not even going to consider the psychological damage caused by a large loss. Let’s ignore that for now. What I’m talking about is basic mathematics. I’ll demonstrate shortly, but essentially it takes a higher percentage win to recover a loss. This was not understood by the newbie trader in our discussion, and it took a few examples before the fog cleared and he really got it, so let’s go through a few examples here. Let’s say you lose 50% in one trade, and then gain 50% in the next trade. Where does that leave your account? Back where you started? WRONG! Losing 50% and then gaining 50% takes you to only 75% of your original equity balance. You’re still down by 25%. Let’s use some real figures: | | Account Balance | Opening balance | | $10,000 | First trade: loss of 50% | -(50% of $10,000) = -$5,000 | $5,000 | Second trade: win of 50% | +(50% of $5,000) = +$2,500 | $7,500 |
So, we lost 50%, and we gained 50%, and we ended up dropping from $10,000 to $7,500. Ok, some of you might be thinking, what if the win comes first. | | Account Balance | Opening balance | | $10,000 | First trade: win of 50% | +(50% of $10,000) = +$5,000 | $15,000 | Second trade: loss of 50% | -(50% of $15,000) = -$7,500 | $7,500 |
Hmmm. Exactly the same result. The fact is, if you lose 50% of your account, you then need to make a 100% return to get right back where you started. And trust me, it’s a lot harder to make a 100% return than it is to lose 50%. Let’s do the maths again, losing 50% and then making 100%. | | Account Balance | Opening balance | | $10,000 | First trade: loss of 50% | -(50% of $10,000) = -$5,000 | $5,000 | Second trade: win of 100% | +(100% of $5,000) = +$5,000 | $10,000 |
So, we lost 50%, and then gained 100%, and we’re right back where we started. This works with any percentage loss. A loss of 20% requires a gain of more than 20%, just to get back to breakeven. Let’s check it out: | | Account Balance | Opening balance | | $10,000 | First trade: loss of 20% | -(20% of $10,000) = -$2,000 | $8,000 | Second trade: win of 20% | +(20% of $8,000) = +$1,600 | $9,600 |
It actually requires a 25% win, to recover a 20% loss: | | Account Balance | Opening balance | | $10,000 | First trade: loss of 20% | -(20% of $10,000) = -$2,000 | $8,000 | Second trade: win of 25% | +(25% of $8,000) = +$2,000 | $10,000 |
If you didn’t hate mathematics before, I’ll bet you do now. Now, some of you may be saying that this is all fine in theory, but you’d never lose 50% in one trade. Well, I’m happy to hear that. However what about a gradual loss over a series of trades, totaling 50%? What drawdown are you willing to tolerate to your account? If you allow a drawdown of 50%, then you need a profit of 100% on that new equity balance, just to get back to the starting point. And profiting by 100% is going to be tough if you’re using the same strategy that has already led you to a 50% drawdown. How much drawdown are you willing to tolerate? A 30% drawdown will require 42.86% profit, to get you back to square one. A 20% drawdown will require a 25% profit, just to recover your losses and get back to breakeven. Let’s look at the percentages required to recover losses, across the full range from 10% to 100%: Percentage Drawdown | Percentage Profit Required to Recover your Drawdown | 10% | 11.11% | 20% | 25% | 30% | 42.86% | 40% | 66.66% | 50% | 100% | 60% | 150% | 70% | 233.33% | 80% | 400% | 90% | 900% | 100% | It’s just not going to happen! |
How much drawdown can you tolerate? If your strategy loses 60% of your account, it now has to produce a return of 150%, just to get back to breakeven. How likely is that to happen? And if you’re stupid enough to lose 90%, well, maybe it’s time to look for a new career. You’re going to need a 1900% return, just to get back to your starting point. That’s tough going. So, where does this leave us? 1. Respect the risk in the market – if for no other reason than to save yourself from having to explain to your family where all your money went. 2. Make capital preservation your number one goal – survive to trade another day, through a professional application of risk and money management. 3. Learn with small amounts – don’t place all your life savings in the market because you probably will lose large percentages while learning. 4. Start off on a demo platform. When you’re profitable on a demo, only then should you move to a live platform. And then start off live with the smallest position size that your market or broker will allow, and gradually increase size as you demonstrate success at each level. Manage your risk, and survive to trade another day. Happy trading, Lance Beggs Risk Manager http://www.YourTradingCoach.com (c) Copyright. 2008. Lance Beggs. www.YourTradingCoach.com. All Rights Reserved.
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