How Much Of Your Trading Capital
Should You Risk?
By Trading Secrets
What is a Small Loss to Your Trading Capital?
Remember, the goal with your trading capital is to keep your losses as
small as possible while also making sure that we open a large enough position
so we can capitalize on profits as well.
So the question becomes, regarding trading capital, what is a small loss?
Well, theyre usually represented as a percentage of your trading float,
and studies have been done that suggest you should never risk more than
two percent of your trading capital on any trade. However, most pros will
tell you that this is way too much. Theyll risk one percent to even as
little as a quarter of a percent on any trade.
The idea here though is that no one trade is really going to affect your
trading capital either way. I really believe a lot of people dont actually
appreciate how powerful this rule is. To be honest, by simply changing
the amount of trading capital you risk, you can turn a system from returning
10 percent to a 100 percent per annum by simply altering this one variable.
Ultimately, by increasing the risk to your trading capital, yes you increase
your chance for reward, however, you also end up increasing your draw
down as well, and although I recommend you never exceed two percent risk,
I do recommend that you do a little bit of testing to understand the importance
and the power of changing this one variable. But, lets look at an example
of the two percent rule in action. If we had a trading float that was
20,000 dollars, by setting the two percent rule, we set our maximum loss
to our trading capital to be 400 dollars on any one trade.
The beauty of having made such small losses to your trading capital with
the two percent rule is that we need a huge string of losses before our
entire trading float is eroded. If we had a 20,000 dollar trading float
and maximum loss was 400 dollars, we could have a string of 50 losses
in a row before we had no more trading capital left.
With most trading systems the chances of getting 50 losses in a row is
very, very slim. However, the chances of going broke and losing all your
trading capital are even smaller than that because when you implement
the two percent rule correctly, that two percent is actually calculated
on the current float size.
Initially, two percent of 20,000 dollars of trading capital is 400 dollars.
However, if we experienced a loss first off, our trading float would now
be worth 19,600 dollars. We calculate two percent of this new value of
our trading float, and set this as our maximum loss for our next position.
Two percent of 19,600 dollars would be 392 dollars, so you can see the
effect each time our maximum loss to our trading capital would shrink.
As the portfolio increases in size, were happy to take on more risk to
our trading capital as well. I thought Id play around with a few of the
figures just to see what would happen if we had a string of six losses
in a row. Our trading float after receiving six losses in a row would
have decreased to only 17,717 dollars. Thats after six successive losses,
and weve only lost 2,283 dollars. Now, thats managing your risk.
Being such a small component of our trading float makes it much easier
to gain back those losses. In this example, weve lost a little bit more
than ten percent. To gain back a ten percent loss, well need to make
11.1 percent gain to get our trading float just back to break even.
Now, imagine if we didnt have good money management in place and we had
a draw down of over 50 percent. If we have a draw down of 50 percent,
we need to make 100 percent return on our remaining trading capital just
to reach break even. So, you can begin to see the bigger the draw down
the more difficult it is to pull yourself out of that.
Remember, novices risk more than two percent of their trading capital.
Now, you know better. Also, if youre starting out with a small trading
float, thats no excuse for practicing poor money management. Your goal
in trading should be trading to survive. If you can survive in trading,
the profits will come and your trading capital will increase.
What you need to do is position yourself so that you can endure long
strings of losses to your trading capital, so that when the market
does turn around, youre already in the market positioned to capitalize
on those moves, and thats what setting the maximum loss is all about.
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