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New traders sometimes have visions of making a lot of money very quickly. The possibility is clearly there. The reality is that they will
probably lose all their trading money due to poor risk management.
If you have a trading system that produces 60% winners, and the winners have a normal distribution, then you will have several instances
of six losers in a row in just 300 trades. In 1000 trades you will have several instances of back-to-back sequences of 6-9 losers in a row
with only one or two winners in between.
Ralph Vance did an experiment with 40 PhD's in which they would gamble 100 times in a game where they would be guaranteed to win 60% of
the time. They started out with $1,000. If they had bet exactly $10 on each round they would have each had $1,200 left at the end of the
test. If they had bet the mathematically optimal amount of 20% then they would have had $7,490. However, only 2 had more than $1,000 at
the end of the test.
If you lose 20% of your account then you need to earn 25% profits to get your account back to where you were. If you lose 25% then you
need 33% in profits, if you lose 40% then you need 67% in profits, and if you lose 50% then you need 100% in profits to get back to even
money. With each loss your account is
getting smaller and you are using more leverage on each trade to maintain a constant trade size.
If you take too much risk, then you will lose all your invested money -even if you are smart and have a very successful method of trading.
To thrive in trading you need to be able to survive the inevitable setbacks.
A better approach is to use a system where you set aside a reserve that is used to restock you trading account. When you are making money
then set aside your profits in a cash reserve. Keep the cash reserve at a constant ratio to your trading cash. I would suggest at least $1
in your reserve for every $2 in your trading cash. When you start losing money then don't worry about maintaining your reserve ratio, use
it to restock your trading cash. In this system it takes 50% of profits to recover from 50% of declines. After you start winning again,
restock your reserve with the profits until you are back up to normal levels. This reserve can be just a paper account with the funds actually
mixed together in to your main trading account.
When a trade is a loser, avoid thinking that you know why it is a loser and inventing some rule to prevent it. You probably don't know why
and your trading rule will probably work against you. If you see a frequent pattern that occurs around losing trades then
you can try modifying
your system to avoid this COMMON problem.
B.F. Skinner authored an important work on behavior in the Journal of Experimental Psychology. Pigeons were fed with a timer regardless of
their behavior. The Pigeons generally identified the feeding time with the wrong cause. One bird believed that turning counter-clockwise at
least 2 or 3 times was the cause of the arrival of food. Another repeatedly thrust its head into one of the upper corners of the cage. A third
developed a 'tossing' response, as if placing its head beneath an invisible bar and lifting it repeatedly. Two birds developed a pendulum
motion of the head and body. Many traders act the same way, developing trading rules that have nothing to do with actual causes. These rules
tend to destroy rather then improve their trading system. A good trading system should not be changed when you get a few losers in a row.
There are two questions that you ned to ask yourself in risk management: 1) Do I feel like this trade will make me a big profit as a percent
of my trading account size?, and 2) Does the level of risk feel a little scary?
If you can answer yes to either of the above questions then you have too much risk. With every trade that makes a good profit you should have
the feeling that you missed out on a great opportunity if you only had more on the trade (But don't do it!). With each losing trade you should
feel "good thing I didn't have more on that trade".
The last point is in the video below. Never add to a losing position to try and save it. If you went in light and adding more later was part of
your original trading plan, then you can add to it.
Never double down to save a trade
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