Many traders focus on managing trade entries and exits, seeking alpha. Most traders learn the hard way after having trouble with pressure, impulses, and ego force them not to execute their trading plan. Risk management generally is learned last, after discovering the impact that lost capital can have on confidence.
It takes increased effort to return to breakeven if you keep trading your base capital away. You need a +11.1% return if you’re down -10% to get back to even. Throw yourself down -20%, and render yourself complete again with a return of +25%. When you lose -50% of your overall trading account you need to double your money with a return of +100% just to get back the way you came.
Returning +1% on your total capital ten times to get a return of +10% is better than trading big trying to get everything at once. When you lose 5 times in succession when risk 1%, you’re down -5%. If you’re going to risk 10% on each trade and lose 5 times in a row, you’re going to be down -50%.
No trade should endanger your entire portfolio, and your first drawdown should not be able to wipe you out. Can your current position size withstand a losing streak of five trades?
Your risk/reward ratio is another key metric in money management. To risk $100 for the chance of earning $300 or $500 is a good trade, and you can will just half the time and still be profitable. To gamble $1,000 to gain $100 is a poor trade. One loss takes out ten winners profit, even if you lose money with a win rate of 90 percent. You want to gamble a little for the chance to make a ton.
Proper position sizing and stop-loss placement are two of the best tools for money management.
- A trade risking 20% of your overall capital allows for a 5% stop loss, which equals 1% of the total trading capital.
- A trade risking 10% of your overall capital allows for a 10% stop loss, which equals 1% of the total trading capital.
- A trade risking 5% of your overall capital allows for a 20% stop loss, which equals 1% of the total trading capital.
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