Surviving failure periods
It is said that risk management makes 90 % of success in trading. Becomes cliche isn’t it ? Place stops, never over-leverage, never leave positions open over weekend, etc…
Now it looks quote boring, but why it is so tremendously important ?
Rule # 1. Sooner or later the string of failure trades will happen.
There is nothing about you or your trading system. This is pure math and market literally says: “Nothing personal gentlemen, just business !”
Look at below table. The modeling by Monte-Carlo method demonstrates that probability of 10 losing trades in a raw for a trading system with 50 % win rate will be around 9% in a sequence of 100 trades ! This is basically one months of active trading !
Now, probability of 5 losing trades in a raw will be a striking 95 % ! And probability of 7 losing trades in a raw is almost 52 %.
Now, think about it. There is a random distribution of winning and losing trades – no matter what your trading edge is. And it is one of the most valuable lessons that I can teach you about trading. Sooner or later you will face a series of loosing trades and it is almost guaranteed.
Now this is where importance of the risk management could be seen. Most traders fail even if they are using a winning trading system. This could be a long streak of failures and you should be able to preserve a capital and continue trading after.
Rule 2. Risk only 1-2 % of your current equity in every trade.
And what does it mean for your your equity?
Imagine the worst possible situation. If you risk 5 % of your initial equity at every trade, then 7 consecutive losses ( and we know its probability is almost 52 % ) is around corner. So, you start with account of USD 100,000 – and with this string of imminent failure you are down to USD 65, 000. Two third of account is done !
This result will ruin a beginner. And that is exactly what normally is happening – lost dreams, lost money and blaming letters to regulators.
Now imagine you use 5 % of your current equity at every trade. Situation is a bit better – you are at USD 69,833 after 7 losing trades.
It is a very important concept – always bet a percentage of your current equity NOT initial investment. This is a very common mistake.
But even this example demonstrates that betting even 5 % of your equity in one trade is too much aggressive. Would be much more wise to risk 1-2 % per trade. Remember, our goal is to survive for another day.
Rule # 3. If you are winning, increase your bet. If you are losing, decrease.
Case 1. John is a gambler, he wins and feels rich, then he is afraid of losing his hard earned money. So he bets a smaller amount of money on the next trade. And then he is losing, he becomes angry. He bets a larger amount of money to recover the losses quickly.
John risks less when he is winning and risks more when he is losing.
Case 2. Tom is a serious trader. He makes exactly the opposite decisions. When he is winning, he bets more. When he is losing, he bets less. It sounds really strange and counter-intuitive. Increase your bets when you win, not when you lose.
This is tremendously important. Often happens that after 3-4 winning trades, traders does not take the next signal – because he thinks:”enough, I was lucky and I earned. Let’s stop it or I will lose”.
This is only the demonstration of the fact that trader does not believes his own trading system!
If you trading system has a winning probability, the more you trade the higher your success chances. This is exactly what casino’s are doing!
This is one of the simplest yet working money management systems and it addresses the relationship between growth and risk. The position size increases as a function of profit and loss, hence rewarding the higher performance with more position and vice versa.