Learn How to Trade Profitably

By John Pontikas and Brian Dibbins

Chapter Eighteen

Money and Risk Management

The following chapter from the Learn How To Trade Profitably eBook is included in our free sample. By signing up to our mailing list you will receive instructions on how to download your own copy of the free sample. Click here to sign up now.

If you have any questions relating to the topics in our eBook that you would like to have answered, please send them to our email address; support@tradeprofitably.com.

This chapter discusses money and risk management, which is crucial if you want to trade profitably. By taking high probability trades and only trading with the trend you can improve your chances of success, but it is effective money management that will let you experience a sequence of losses without eroding your trading bank beyond repair.

Money and Risk Management

[Please note that this eBook sample contains only a partial extract of this chapter that has been modified slightly for this sample.  The full eBook expands on this topic and also includes information regarding the money management strategy adopted by the authors]

Strict money management is one of the most crucial aspects which will verify the success of a trader.  Even with an ordinary trading system, one can be successful and profitable providing good money management principles are applied.  The most important aspect of trading is preservation of capital first, followed by making money.

We only take high probability trades, hence we only take the trades when the odds are stacked in our favour.  This is one of the main reasons that we only trade in the direction of the trend.  A high probability trading system states that when “X” happens, more often than not “Y” will result.  Without strict money management principles though, one’s capital can be eroded very quickly.

For example, assume a trader is implementing a system that is successful 70% of the time.  Even with such a high probability system, this trader will at some stage experience an anomalous run of continuous draw downs.  What if this trader was to lose on the first 30 trades and then win on the next 70?  The first rule of trading is to preserve our capital and not to over commit on any particular trade.

Perhaps this sounds like an extreme example, but it has happened and continues to happen.  If one was to take a coin and flick it in the air numerous times, eventually the odds of getting heads or tails will even out to fifty-fifty.  This is of course after the coin has been flicked numerous times.  Since the coin has no memory though, the likelihood of flicking heads ten times in a row is a possibility.  Will the trader’s trading bank allow for such an event?

We need to know that we can recover from a possible drawdown.

One common mistake amongst traders is that they believe that if they were to lose 20% of their $20 000 bank, they only need to make back that 20% to bring them back to break even.  That is wrong.  In actual fact they need to make back 25%.

 A 20% drawdown of $20 000 brings the bank account to $16 000.  A 20% gain on the $16 000, takes the bank account to $19 200, still $800 short.  A 25% gain though brings the bank account to break even position.  The following table may be of assistance to illustrate the point more clearly.

The above is the main reason that every trader must implement stop losses on every trade.

Remember, preservation of capital is the primary objective.

The worst possible scenario, and many traders make this mistake is to double up their exposure after a losing trade. This is a recipe for disaster. Let’s assume our first trade would have resulted in a $1,000 loss, but instead we chose to double up each time rather than take the loss, keeping in mind that we have a $20 000 bank to trade with.