Minimize Your Trading Losses And Master The Markets
The core principle of effective money management is for us to define both our trading float, as well as our maximum trading loss. By capping the amount we’re willing to loose on any one trade, we’re safeguarding ourselves by ensuring any losses we encounter will be minimal. Essentially, the amount we allocate for trading losses should only be a small percentage of our trading float as this acts as a buffer in the event that we suffer from a series of simultaneous losses.
Unacceptably high risks are the primary reason for so many traders failing. Remember, the objective here is to keep losses at a minimum while at the same time allowing ourselves enough room for profits.
Think about it, for a cricket player, protecting your wickets is certainly more important than making runs. Loose your wickets and you’re out of the game. When it comes to trading, we don’t have wickets but we have a trading float instead. Loose that float and you’re also out of the game.
If you’re constantly thinking about your maximum trade loss, don’t let anyone accuse you of being negative. To the contrary, a wise trader views trading as a game of survival and as such, they make sure they remain on the defensive.
A top trader by the name of Ed Seykota was once quoted as saying, with regards to the three elements of trading, that one should: – A) Cut your losses, B) Cut your losses, and C) Cut your losses.
Losses are a part of trading and they’re something all traders experience. Having said this, professional traders have learnt how to deal with losses. They know they need to accept their losses and then carry on. Under no circumstances do they ever allow losses to cloud the judgment because they realize that if they did, the results could be devastating.
In all probability, you’re more than likely wondering how to define your maximum trade loss. Generally speaking, many traders tend to follow a trading rule, what’s known as the “2% Rule”, meaning you should never risk more than 2% on any given trade. However, many of the more seasoned professionals disagree with this as they feel it’s too high. Instead, these traders like to cap their maximum trade loss at 1% or lower. Admittedly, such a low maximum trade loss means no one single loss will have any noticeable impact on you but at the same time, your profits will also be low.
Perhaps a better way of putting the 2% rule into perspective would be for me to use an example. So, let’s say we start out with a float of ,000 to which we apply the 2% rule. In this case our maximum loss on any given trade would be 0. As you can see, with your losses kept this low, it would take many losses to erode your float completely.
To drive the point home even further, with a maximum trade loss of 0, you would need to experience a string of 50 losses before your float would be depleted. However, because the 2% rule is applied to your current float amount and not to the initial float amount, you would actually need even more than fifty losses. Even by the wildest stretch of imagination, experiencing so many consecutive losses is virtually impossible.
Let’s take a look at this in practice:
As I’ve mentioned, when the 2% rule is applied correctly, using your current float amount, the maximum loss amount will decrease as your float decreases. For example, once again using the K float mentioned above, a second loss would equate to a maximum trade loss of 2, this being 2% of the ,000 you had remaining after your first initial loss. If you experience a string of six losses in this manner, then your float would decrease as follows:
Float amount: $20,000
Float after 1st loss: $19,600
Float after 2nd loss: $19,208
Float after 3rd loss: $18,824
Float after 4th loss: $18,447
Float after 5th loss: $18,079
Float after 6th loss: $17,717
As you can see, even after a string of six losses, you’ll only have lost ,283. In my opinion, this is proper trading risk management. Apply this knowledge to your trading and you’ll have a good chance of succeeding.
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