seen many traders be both financially and psychologically debilitated by a
large loss or a string of losses. How many times have you seen people capitulate
after fighting the market by being long and a bear market relentlessly
kills their equity?
Once that bad risk management blows our mind, we are lost as traders.
We will start to do self-destructive things as “double up to catch up.” We
will look to punish a market to make up for our losses. Or we will hesitate
and not put on trades we should put on.
You can have the greatest method in the world but it will be a failure
if you don’t control your risk. All methods take losses. But what if those
losses cause you to be wiped out? You won’t have the money power to
come back to create all those glorious profits that the greatest method will
create.
Bad risk management is perhaps the most common reason for failure
as a forex trader. People tend to overtrade and put on bigger positions than
their equity can handle. They come into forex trading because of some hype
and think they can make a million dollars in the first month. They think that
all they have to do is follow the new system they bought and they can’t go
wrong. They put on a few trades that are way too big for their small equity
and the first few trades go south and they are financially crippled. They are
also likely mentally crippled and think that it is impossible for anyone to
make money in forex.
The hyped system may or may not be garbage. These traders will never
know, because they got blown out so quickly, that they never really gave
the system a real chance to succeed.
As you can see, psychology and risk management complement and support
each other. We always want to be cool, calm, and collected when we
trade and that won’t be possible if we are overtrading or have on positions
that are too large or if we have losses that are too large for our mind. We
need to remain rational at all times when we trade. The stakes are too high
to not do otherwise.
How do you feel when you take a large loss? I thought so. I don’t feel
good either. So it is important that we keep our losses to trivial levels. We
want to have losses so small that we can’t remember them the following
day. They should be so trivial that we hardly notice them and they certainly
don’t cause us any mental pain.
Capital preservation is more important than capital appreciation. I
have seen so many traders come to me for training after they have lost
50 percent of their money. Stop and think about this for a minute. They
need to now double their money just to get back to breakeven! That’s not
easy. They could get back to breakeven in just one trade if they were down
only a few percent.
And think about the psychology of the traders who have lost 50 percent
of their funds? Do you think they are approaching the market in a cool,
calm manner? Do you think their minds are blown? What chances do you
give them to double their money?
Risk management can take a good system and make it a bad one. Bad
risk management will destroy a good system.
Good risk management is more important than having a good system.
Bad risk management can turn a profitable system into an unprofitable system,
but not vice versa.
Let’s play a game. Let’s assume that you are going to flip a coin. Let’s
further assume that you have $100 and you are going to flip the coin 1,000
times. This is a totally fair game. All we are going to do is to change the
size of the bet.
First, let’s assume that we bet $10 on every flip of the coin. That’s
10 percent of our bankroll of $100. What are the chances that we will get
wiped out sometime during our 1,000 coin flips? Turns out that we have
over a 90 percent chance of getting wiped out. The reason is that all we
need is a net of 10 losing trades and we are wiped out. And there is over
a 90 percent chance that we will get that condition sometime during those
1,000 flips.
Now, let’s only bet $1 on each flip. What are the chances now that you
will get wiped out in the 1,000 flips? Turns out to be less than 5 percent
because now we need to get a net of 100 losing coin flips in the 1,000 flips
and the chances of that are very small.
One of the key factors to consider is that the return and risk are
asymmetrical. How can that be when the odds are 50–50 on each coin
flip? Shouldn’t I always end up with roughly $100 at the end of the
game? Nope!
Let’s simplify the game for purposes of demonstration. Let’s assume
that you are going to bet $100 on each coin flip. Unfortunately, you lose the
first flip. There. You’ve lost all your money. You don’t get to play the game
anymore.
Let’s start over. This time you win the first flip so you have $200 in your
account. But then you lose the next two flips. You’re wiped out again and
don’t get to play the game.
Do you see a pattern developing? If you do well, you still have a chance
of getting wiped out. But if you are wiped out, you never get another chance
of doing well. That is why the game is asymmetrical. Each flip is 50–50 but
getting wiped out means that you don’t get to play the game anymore.
That is the situation we have with trading. You may have a good system,
but getting wiped out means you don’t get to trade anymore to take
advantage of that good system. But making money in the beginning helps
you from getting wiped out but doesn’t completely eliminate the prospect.
As a result, we need to have proper risk management to make sure that
we can end up with enough of a chance to make money that the chance of
getting wiped out and not getting to play the game is eliminated.
Risk management is really another name for asset allocation. How we
allocate our precious resources is a major determinant of our eventual
profit.
Risk management determines how fast or slow we grow our portfolio.
Our portfolio will grow too slowly if we take too little risk, but we will
have little chance of being wiped out. On the other hand, our portfolio may
grow very quickly if we take big risks, but we run a high chance of getting
wiped out. Can we find the point where we have little risk of being
wiped out yet still have a great chance of growing profits in a dramatic
fashion?
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
