result in losses instead of profits?
I strongly believe that once a trader has honed his or her trading skills, the ultimate
factor that will affect his or her overall profitability is money management skills.
Money management is all about managing the possible risks, and it is the defining
factor that separates winners and losers in forex trading. Novice traders think of
how much they can harvest from the market; experienced traders think of how
much they can lose to the market. Many traders are so eager to trade to make big
money that they completely overlook money management. Poor money
management also explains why so many traders get wiped out by the market. The
first goal of money management must be to ensure long-term survival in the
market, because if you don’t survive to trade another day, you can forget about
profits altogether.
Money management is about fully optimising your trading capital. It allows you to
be proactive in managing risks, and to cope with trading losses – which are part and
parcel of the game. It is an essential tool to ensure that you will have more than
enough to last another day in the trading game. It is possible to have a trading
system that yields 90% accuracy but still end up losing if the trader does not handle
his or her money and portfolio properly. No matter how good a trading system may
be, there will be times when you will experience a series of losses. Success comes
to those who have set down rules for money management, and have the discipline
to follow them through their trading.
Preserve your capital
The shining light that attracts all traders to the forex market is the prospect of being
able to grow their money by tapping into the online trading platform as their own
in-house money tree. In almost any field, it is true that most people are drawn to
short-term benefits, but are myopic when it comes to long-term planning. Trading
is no exception.
When risk capital is put aside for trading, you are hoping that this amount of money
could be transformed into a much bigger amount; otherwise, what would be the
point of risking it? But if this capital runs out, what can you bank on to make your
desired profits?After all, money begets money. Hence, preservation of capital is the
key to ensuring a trader’s long-term survival in the market, for, without survival,
there can be no wealth generation.
To drive home the importance of capital preservation, I will discuss the concept of
drawdown, and how that is relevant to money management.
Drawdown
Drawdown refers to the decline in account equity from a trade or series of trades.
In other words, it is the amount of money that you lose – it is usually expressed as
a percentage of your total trading equity at any given time. Drawdown is not an
indication of your overall trading performance, as it is calculated when you have a
losing trade against your new equity high or your original equity, depending on
which is higher.
For example, you start with a trading account of $10,000, and lose $2000. Your
drawdown would be 20%. Now you are left with $8000. If you subsequently gain
$1000 and then lose $3000, you now have a drawdown of 40% ($8000 + $1000 -
$3000 = $6000, which is 40% loss on your original equity amount of $10,000).
But let’s say you do not have a losing trade, and have made $3000 on your $10,000
trading capital, so that increases your trading equity to $13,000. However, you then
lose $2000 out of $13,000 on your next trade. Your drawdown would be 15%
($13,000 - $2000 = $11,000, which is a 15% decrease from the new equity high of
$13,000).
An important thing to note is that a 100% drawdown will wipe out your trading
account, regardless of whatever percentage you are up in your trading account.
Recovering from drawdown
As drawdown gets bigger and bigger, it becomes increasingly difficult to recover
the equity. Many people are not aware that in order to recoup the percentage of
equity that they lose, they will need to gain a bigger percentage just to break even.
If you have lost 10% of your capital, do you think you can break even with a gain
of 10%? The answer is no. It will require an 11.11% return on your new account
balance for you to recoup that 10% loss. Let me show you with numbers.
Let’s say, you start with an initial trading capital of $10,000 and lose $1000, which
is 10% of your capital. In order to recoup that $1000 loss, you will need to make
$1000 out of your $9000 remaining balance, which is equivalent to 11.11%
($1000/$9000 x 100).
OK, that is not scary yet, but if you start losing more and more of your capital
(bigger and bigger drawdowns), the faster you will go down the rabbit hole. Refer
to the table opposite:
As you can see, while losses increase arithmetically, the gains that are needed to
recoup them increase geometrically.
For an 80% drawdown, can you imagine quadrupling your account just to
break even?
While many traders hope for that One Big Win that will magically transform them
into millionaires overnight, they are more likely to be confronted with the One Big
Loss that will threaten their survival in the forex market if they do not exercise
careful money management. If a trader has a big loss, he or she will have to spend
more time to get back to where he or she was before, instead of using the time to
make profits. Traders who burn out quickly in the market are those who do not
show respect for risk. On the other hand, traders who have flourished are those who
fully understand the importance of stringent money management and incorporate
that into their trading approach. There is no way around to recouping slowly, unless
you want to drive yourself to total destruction by risking more and more of your
equity to try to make back your losses. Holding on to a losing trade for too long is
the biggest cause of a big drawdown.
Be well-capitalised
Most new traders run out of money even before they see any profits in their trading
account. Indeed, those who are new to trading most likely do not have a good
understanding of the risks and dangers that are lurking in the market, and few even
know what drawdown means or have even heard of this word. Many of them do
know that trading can be very risky if they do not know what they are doing or how
things work in the currency market and, to them, one of the obvious but incorrect
ways to limit this risk is by allocating just a small amount of money to their trading
account. They think that they should not be investing too much money into a
business start-up before it starts to generate profits. There are also many new
traders who begin their trading business with little initial capital as they simply do
not have enough money. Whatever their reasons may be, being under-capitalised
will be more than just a mistake; it is often the prelude to trading failure.
Forex traders who want to set themselves up for success must be well-capitalised.
Never mind that some retail brokers are offering a minimum account deposit of just
a few hundred dollars – a paltry amount that almost every one can afford. Sufficient
initial capital must be available to cushion the impact of a string of consecutive
losses, so that you do not wipe out your trading account. A series of losses is really
not that uncommon in trading, and all traders must be financially prepared for it.
Those with insufficient trading capital tend to set really tight stops, which will
naturally then lead to a higher probability of being stopped out. They also tend to
have a good chunk of their account eaten away by unreasonably large losses in
relation to their trading account, if they do not set tight stops. So it seems that
whichever way they turn, they are setting themselves up for failure, unless they are
willing to trade smaller lot sizes.
Looking outside of trading, many other businesses fail because the owners often do
not have enough capital to tide them over the initial starting phase. For example, a
new restaurant owner must set aside enough money to pay the rent of the restaurant
for at least a few months to a few years, assuming that the restaurant would not
make any net profits in that period of time. If the owner only has enough to pay for
two months rent from his or her own pocket, and the restaurant is still not making
enough to cover the rent and other expenses in the third month, how do you think
the business is going to sustain itself? The entire business could fail, not because of
the business model, but because of the lack of sufficient capital to keep the business
running while the customer base builds up. Trading, as I have mentioned before,
must be treated just like any other business, not a frivolous casual pursuit.
The point is this: by starting off sufficiently capitalised, you are more likely to
adhere to your money management rules and, by doing so, you are really giving
yourself a good fighting chance in the market. Don’t cut yourself short.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
