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.
Don’t make the same mistake that so many traders make by risking too much. Instead, you should aim to keep losses at an absolute minimum, keeping in mind though that you also need enough freedom of movement in order to benefit from profits.
A very famous cricket captain once said that the most important aspect of the game, is not to make runs, but to stay in the game. I mention this because it’s so true with regards to trading as well. Your primary goal should be for you to protect your trading float just as that captain sought to protect his wickets. If you loose your float, you’re 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.
Being a firm believer in keeping trading losses to a minimum, a top trader by the name of Ed Seykota once defined the 3 elements of trading. He said,”Follow these three rules and you just have a chance”, 1) Cut your losses, 2) Cut your losses and 3) Cut your losses.
Whether you like to believe it or not, you will experience losses along the way and there is nothing you or I can do to avoid them. However, the trick is to accept them and then to move on. Whatever you do, never allow losses to obscure your better judgment because in trading, keeping a clear head is vital.
What is the ideal maximum trade loss? According to many studies, the ideal figure seems to be 2% of your trade float, hence the well known 2% rule in trading. Of course there are also scores of professionals who refuse to risk more than 1% of their float on any one trade. Remember though, while this certainly minimizes the effect of any losses, it also means your profits won’t be very big.
The advantage of applying the 2% rule is, if for example we traded with a $20K float, the maximum loss we could incur from a single trade would be a mere $400. As I’m sure you’ll agree, we would need to experience an unlikely number of losses before our float would be lost completely.
At $400 per trade loss, you would need to have fifty losses one after the other before being broke. On the other hand, the 2% rule is not based on your initial float but rather on your current float amount. In other words, even after more than fifty consecutive losses, you would still not be broke, and I’m sure I don’t need to point it out, just how unlikely such a string of losses really is.
Let’s take a look at how this works:
Starting with a $20K float we have our first loss based on the 2% rule. As we know, this would me we loose $400 which in turn leaves us with $19,600. Once again, we apply the 2% rule on our next trade, thus meaning the maximum loss we expect would be $392. Now let’s see what happens when life treats us really bad and we experience a string of six losses:
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
Even after six consecutive losses, we’re still left with $17,717 in our float. If you ask me, this is what I call, “Risk Management
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