Bringing order into your risk management technique

I'll be away from the 19th April till the 4th May so I won't be around to produce new content. I decided to to re-publish old blog posts that focus on the psychological aspects of trading so I hope you enjoy! See you soon 

Improve your trading with the 2% rule

When it comes to trading the success of your endeavours is a function of your ability to contain your losses so as not to let them get out of hand and create mass portfolio destruction.  Debate around the different forms of risk management within the trading process is wide ranging and somewhat complicating for the new trader. So today I want to highlight probably the most known risk management rule so that you are able:

·         better understand the concept around controlling your losses

·         you have a foundation from which to work from towards other methods

So the first thing we want to understand is that when it comes to trading there are always time when you are going to lose, period. If you hear or see a person claiming to have a 100% full proof system it’s a lie. Trading is about probabilities of certain patterns working in your favour but take note having probabilities do open you up to also working against you.

 An easy way to think about this is by envisioning a champion sports team playing against a minnow.   The odds are in favour of the champions because they wouldn’t be self-declared champions without proving themselves through a series of matches against various opponents at every level.  However nothing stops the minnow team from playing with skill only. They could bring a valiant attribute to their game and shock fans and the world over by upsetting the odds and winning the match.

What evokes such a trait to beat the odds?

 Answer: human emotions simply as that.  Whether it be arrogance and overconfidence on the part of the champion team or bravery and ambition from the minnows.  Human emotions have the tendency to make the impossible become possible.

The same emotions experienced in sports are identical to the feelings you’re going to encounter when trading which is why you have to have plans in place to stop you from making costly errors.  Can you imagine a team with no manager that concedes a goal, a try or even a wicket against itself? It would be panic everywhere as there is no clear tactic with how to deal with the situation which leaves the team vulnerable to similar offensive plays putting them in a worse position. 

The same applies if you were to take a trade for no reason and suddenly slip into losses. With no clear rules your mind would run ragged trying to figure the best plan of action but in a constantly price changing environment. 

Now that we've built a case for why you need to be employing risk management let’s get down to the real business of the day and that’s to understand how the 2% Rule works.

   

It’s quite easy. So let’s assume you have a R50 000 account. The premise of the rule is you are not willing to lose more than 2% of capital on one trade. What does this mean? Simply put if you were taking a trade you won't be willing to risk more than R1000 (R100 000 x 2%). If you lose you are only losing R1000. But why do we use 2 per cent?

On the table below you’ll see the percentage needed to reverse a loss back to breakeven in terms of your capital.  On the far right hand column is the balance after incurring a loss at each particular percentage. The column before that is the amount the loss would equate too.  The middle column shows the percentage needed by a winning trade to go back to breakeven. The last 2 columns represent the loss as a percentage of the account and the starting capital.

So let’s assume the worst and you lose all your money, basically there’s no chance of you getting it back since all your money in the game is gone. Next would be 75%, you would need to increase profits 3 fold to get back to break even.  Now I’ve seen in my experience guys who find themselves in this position and try desperately to get back to these levels and over gear themselves and that eventually leads to even bigger losses. This is rife among new traders who fail to employ proper risk management principles.

As you go up the table you see that the less you lose the less the percentage needed to recover from the losses. Take 10% for example you’d only need 11.11% but to risk 10% on one trade means 10 trades gone wrong and you’re done. Let’s face it, as a new trader it’s possible to make mistakes and 10 wouldn’t be impossible for a new person starting.

But now here’s a thing, at 2% loss, you would need to lose 50 times to wipe out your account and that I can say it virtually impossible to do.  This way you are allowing yourself enough capital at risk for you to be able to master the markets and at the same time having risk in your favour.  

Now let me tell you from first-hand experience mastering the markets is no small feat so having risk on your side makes all the sense. Although the gains will be smaller compared to the same trade but larger exposure you have a greater chance of surviving severe market conditions when your system does not respond to the market and thus saving yourself from trading disaster. 

 It’s important to note that this is not the only method of managing your trading risk. There’s always been fierce debate regarding the merits of each method. We not here to debate that but if there is one distinct characteristic of this method it’s that it’s relatively simple to understand and implement. Especially for new traders who don’t have the skill or expertise in trading and require an effective risk management rule to keep them in the market for as long as possible because at the end of the day the longer you stay in the game the better your chances of long term profitability.