You hear all sorts of great traders say that risk control and money management are the pillars of trading success. After you have a trading system that has an edge this is of course very true.
You hear them talking in cliches about how you should cut your losses and let profits run. They talk about how you should not over trade. How if you suffered losses that you should not attempt to make the money back right away. They talk about how you should not try to leverage up to make back any lost money. They tell you about position sizing and how you should not risk more than 1% or 2% on any one trade idea. They warn you about getting shaken out of trades because you are using too much leverage.
In order to fully understand the implications and meaning of the above let me give you example of two traders. Assume that position sizes and percent risk are calculated from starting account equity. In other words if you have $20,000 in the account and risk 10% per trade, you will be risking $2,000 on the next series of trades even if your account equity dips below $20,000. Meaning that if you suffer a loss and are down to $18,000 you are not going to risk 10% of $18,000. You are going to risk 10% of your initial account equity. So the following are rough assumptions that you will not recalculate % risk after every trade.
Trader #1 likes to go for the jugular on every trade. They like to risk 10% or more on every trade. They can change their bet size wildly as their emotions are shifting throughout the day. This traders knows that they he has a good system, if he can stick to it and only trade when the signal truly fires off. This trader wants to trade with high leverage and believes that his system has win rates. He knows that the high leverage necessitates high win rates and thus should only trade just a handful of times every month.
The problem is that this trader has gone one week without placing a trade. They have spent 40 hours watching the markets and has yet to place a trade for the week or month. This trader is getting antsy. He knows that he has a good system and know that he should only trade a few times per month. But he also wants to try to use trading profits to pay for a sudden need.
This trader diligently performs the daily analysis that his system requires. But one day he decided to start to fudge the entry rules of his system. Perhaps he sees a pattern that is close to this signal, and then decides to take it before completing his analysis or before asking the right trading questions. They take the signal, and the trade turns out to be a loser.
This trader is down 5-10%. He is getting a little antsy now. He knows he has taken a sizable loss. He also wants to make sure he can generate a profit and pay for any sudden needs. This trader decides to maintain the high leverage and risk a huge amount on the very next trade as well.
The problem is that this trader did not put any time between his recent loss and the very next trade he decides to place. Instead of waiting at least a day or so, this trader decides to place another highly leveraged trade within the next few hours after his big loss. He wants to leverage up and make the money back right away.
The trader finds another trade that slightly conforms to his trading system, but not the perfect signal as described in his trading rules. Trader #1 places a highly leveraged trade again. This time the market bobs in and out of profit. The trader knows that he has a lot of money on the line for he is risking 5-10% on one trade. The market is sitting at a small loss and the minutes and hours are ticking away. The trader wonders if the trade is going to cause him another loss. This trader decides to bail out prematurely with only a portion of the loss he would of sustained if he held the trade for the full loss. But with the immense leverage he was losing he still lost a lot of money as even small movements can represent a large % of their account. The trader finds himself down a few more % points.
This trader is kicking himself for not staying in the trade as the trade did eventually work out, but he was shaken out because he was scared of the small fluctuations against his position because of the high leverage used.
The trader then resolves to place a third trade, using the same high leverage but decides to stick it out until the profit target or stop loss is tripped. The trader finds another trade, that is a decent signal, but still not the best required by his high leverage system. The third trade turns into a full loss.
Now this trader has gone from being down 10% in the first trade, to being down 13% in the second trade, to being down 20% by the end of the third trade.
This trader continues the high leverage and attempts to make the money back right away.
Finally on the fourth try the trader finds a good trade, leverages to the max risking 10% of his account, and the trade turns into a spectacular winner like his system says it should. This trader makes back and winds up up a few percentage points. This trader went from being down 20% to being up a few percent because that highly leveraged trade finally paid off with a reward risk ratio between 2 to 1 and 3 to 1.
This trader has certainly experienced a very volatile and wild ride in account equity. Being down 20% to recouping the losses all within one day, or a few days is very volatile indeed.
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This trader doesn’t have as good a system as Trader #1. His win rates are lower, thus necessitating lower risk per trade. This trader knows that he should only risk 1% of his account equity on one trade.
The trader finds the first trade that conforms to his trading system. He places the trade diligently, but it winds up being a loss and he is down 1%.
The trader knows to place some time between the trading loss and the next trade so they take the day off or take a few days off.
The trader comes back to the market with a clear mindset and no emotional attachment to the previous loss. He finds another trade and places the same 1% risk. The trade turns out to be another loser. The trader is down 2%.
The trader takes the same day off or few days off between trades.
The trader places the third trade. It turns into another 1% loss. The trader is down 3% so far.
The trader comes back to the market to place the fourth trade. He risks 1% again. The trade bobs in and out of profit. Trader #2 is not afraid of the small fluctuations against his position, for he knows he is not using a lot of leverage. The small fluctuations represent small portions of account equity – perhaps 0.10% or 0.30% of his capital. He is not going to get shaken out. Trade number four turns into a small winner and the trader makes back a small profit of 1%. The trader goes from being down 3% to being down 2%.
Trade number five comes and the trader takes it diligently following his trading system. Finally the huge winner comes into play that nets him a profit of six to one on his money. The trader risked 1% and made 6%. This trader went from being down 2% to now being up 4%.
Both traders winded up being up a few % points after a series of trades. The difference lies in the fact that trader #1 went through a wild draw down periods where he was down 20%, then was able to recoup losses to being up a few percent.
While trader #2 took a series of losses as well, but was only down 3%, and was able to make the money back with a well timed trade that turned into a sizable winner. This trader was only down 3%, but wound up being up a few percentage points as well.
Trader #1 used massive leverage.
Trader #2 used small leverage.
Trader #1 is at risk of a massive death spiral that could be caused if he suffers a series of trading losses. If he took a loss on the last trade, he would of wound up being down over 20%. Being down that much can cause a lot of emotional pain, and the risk of a death spiral can increase drastically. Account equity depletion and blowing of trading accounts is what can happen.
Trader #2 is at very small risk of a death spiral. Why? Because recovering from a 3% draw down is FAR EASIER, than recovering from a 20% draw down. Mentally, psychologically it is far easier. Chances are if you are down 3% you are not going to go into a death spiral.
You will be able to be in a mental state to execute your system and recoup any losses.
Also, lets say you have a $20,000 account and are down 20%, which brings your equity to $16,000. In order to get back to even you do not require a 20% gain. You require a 25% gain!
The trader that was only down 3%, bringing account equity down to $19,400 only requires a 3.09% return to get back to even.
Now you may ask what if Trader #1 had posted a highly successful trade on the very first trade, then he would of been up 20% or more. That is true. But the key question is using such high leverage can you have the discipline to only place the perfect trades that have the massive order flow behind them? For high leverage necessitates high win rates. You cannot take consecutive highly leveraged losses or you are finished.