Take Control Of The Markets And Experience Minimal Trade Losses
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.
One of the great things about a sound trading psychology is that it instills in you, a sense of survival and a tendency to be defensive. Always thinking about the maximum losses you're willing to incur doesn't mean you're being negative, it means you're 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.
One fact that all traders need to be aware of is that experiencing some losses is inevitable. When they occur, accept it and move on.
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% trading rule. 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 K float, the maximum loss we could incur from a single trade would be a mere 0. As I'm sure you'll agree, we would need to experience an unlikely number of losses before our float would be lost 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 see how the 2% rule is applied:
Starting with a K float we have our first loss based on the 2% rule. As we know, this would me we loose 0 which in turn leaves us with ,600. Once again, we apply the 2% rule on our next trade, thus meaning the maximum loss we expect would be 2. 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
,717 still in the float even after we've experienced six losses in a row is something we can be proud off because it shows that we're minimizing trade losses effectively. As I'm sure you'll agree, this is exactly what trading risk management is all about.
