As any moderately experienced trader knows, having a reliable system is not enough to be successful.
Besides an understanding of the psyche of the market, money management is the third and according to some the most important weapon in a trader’s armoury.
There are many words and articles written about money management but it all revolves around risk. This article follows on from the previous one concerning “Probability of Bankruptcy.”
It is common knowledge that it is foolhardy to risk more than 2% – 5% of our capital on a single transaction.
It is important not simply in order to “remain in the game” but also psychologically. This is a market where 5-6 losing transactions in a row is not uncommon.
For example, if we start with 10,000 USD and risk 1% in each transaction, after 5 failures in a row we still have more than 9,500 USD. That is not a major concern since the loss is not large. The situation looks different when we risk 10%. In this case, almost half our capital is lost! This brings a mental issue with opening our next position since it will need almost a 100% profit to regain parity.
Consider the probability of such a “losing streak”. If we assume a 50:50 win/loss probability,
Looking at the problem a little differently, in the first row there is a portfolio where we risk 50% of capital and the risk of ruin is 1:4 (win-win, win-loss, loss-win, loss-loss). When 25% is risked, we uneed four losing positions, the probability is 1:16. In case of 5% it is one in a million chance, in case of 2% well, that is a lot of digits!
If we keep these scenarios in mind, we not only protect our capital but have a better psychological approach knowing that there is a tiny probability of bankruptcy. It becomes easier for us to make proper investment decision.
This chart shows the reality and is designed to deaden the alarm bells that may be ringing.
For example, if we risk 2% of our capital per trade, the reality is that 263 losing trades to lose all our capital since the size of the capital diminishes with every loss.