If you read interviews
with top traders, one of the common factors that you will find stressed
repeatedly is the idea of not losing money. In Sport lingo, you
have to be able to play great defence. Whether forex trading, stock
trading, or doing trades in commodity futures, the bottom line is the
same.
Yet too many beginner and
intermediate traders are more interested in playing great offence first.
They are more focused upon making lots of money in the markets, and not
nearly interested enough in keeping the money that they already have!
However, the latter is
critical to your success. Although it is obvious that in Trading, you
have to risk money in order to make money, the idea is to control that
risk so that it is always strictly limited and so that you remain in
control of the situation at all times. In other words, we are talking
about what the investment banking industry calls Risk Management.
It is just as vital for the private trader at home as it is for the
major investment banks.
The reason that investment
banks regard risk management as essential is because without it, they
would go bankrupt extremely quickly. It is at the heart of both their
success and survival. Hence, if it is good enough for them, it should be
good enough for you too.
Beginner traders have no
idea of how to manage their risk, even as a concept. They put on a trade
according to some poorly defined criteria, and when the market goes
against them, they have no idea at what point to get out of the position
and will let it worsen until it is simply too painful to retain.
The smart trader, however,
places risk management at the heart of the entire trading plan from the
very beginning. If you realize that in this game, the target is not only
to make money, but also not to lose the money you’ve got, then you have
made great progress before you even place your next trade.
Let’s put this a little
more graphically. If you were to lose, let’s say for sake of argument,
half of your trading capital, then you have a huge uphill task ahead of
you. You will have to achieve a fully 100% return, simply to break even!
You will have to do even better than a 100% return to actually go into
profit. Now, if you realize that very few of even the sharpest hedge
funds make 100% return on capital in a year, never mind all the other
more mediocre players out there, you will realize what an outlandishly
monumental task this really is.
Yet, if you were to ask
many beginner traders, you will find that it is actually very easy to
lose half your trading capital, or more, quite swiftly. You do
this by placing too large a trading size in the first place, betting on
ill-defined trading opportunities where your chances of winning are low,
and then staying in the position for way too long when it is clear that
it has gone against you and is not coming back anytime soon.
By contrast, the
successful trader is very careful indeed about the sort of trading
opportunities that are pursued and has done diligent research to
identify high-probability trade setups. This trader clearly defines the
risk in absolute dollar terms ahead of even initiating the trade, and
places that limit as a stop loss against the position at the same time
that the trade itself is placed. Hence, the trader has pre-defined
exactly at what point in the market that the trade is a loser and has
placed the exit order at the same time as the trade itself.
Another key aspect to this
procedure is to limit the capital exposed to any one trade. Even
following all of the above strategies would be absolutely no use if your
trade size is far too large proportionate to your account size. If you
enter trades where your potential loss represents one-third to one-half
of your total account size, then you are almost certain to go bust
within just a few trades!
By contrast, great traders
ensure that their loss is not only pre-defined, but also small relative
to their total account size. In this way, they ensure that they stay
in the game. If a great trading opportunity comes up, but you
cannot take advantage of it because you went bust, it is as good as if
it had never happened. That is why you MUST play great defence, and
ensure that you do your very best not to lose money.
You need to stay in the
game. Remember, there will always be another trading opportunity… but
only if you are still in the game!
