When we participate in financial markets, we do so at times when the odds of winning they are in our favor. But since it is a probability, we assume a certain degree of uncertainty. What we do is determine if the price is more likely to increase or is more likely to decrease.
How do we do it? That is the subject for another article (or for a series of articles). Let’s start from the premise that we know how to do it (in fact, what a Trading System basically does is help the trader to clearly identify those moments). What I want to highlight now is a requirement for success in trading that is often misunderstood or underestimated, when in fact it is essential. I mean the money management.
The fact that we participate by “betting” on the listing price of an underlying at a given time futureand that we do so by committing our capital at those moments in which we have a greater probability that the price will move in our favor, necessarily implies that we are positioning ourselves on something that hasn’t happened yet. This point must be very clear: when we operate in a financial market as traders, we are taking positions on the future value of a certain underlying, and by definition, what we are also doing is acting on something that does not yet exist.
The future has not yet been determined, it has not been created, the quantum wave if you will, has not yet collapsed. The moment we take positions we do so about a probability that it will not manifest itself in fact until said event occurs. And this has consequences for the trader that are important. The first is that, in fact, even though what the trader does is act when he has the market in his favor, in reality anything can happen. That there is a probability, for example, of 60% that the price, at a certain moment, will move downwards, also implies that there is a probability of 40% that it will not. If you position yourself in favor of the higher probability, you are still assuming an uncertain outcome, in the sense that until the market has moved, you won’t know if it has moved lower or not.
That is, on the one hand I have to act in favor of what is most likely to happen, but on the other hand, I cannot be sure what will happen until it does happen. It is logical. Because it is important? It is because it implies that I will be taking a risk in each operation that I take and that said risk will exist each and every time that I position myself before something that does not yet exist.
I have a coin in my pocket and I know that there is a 50% chance that it will come up heads when tossed and a 50% chance that it will come up tails. Until I take it out and throw it, I won’t know the result of said throw. Anything can happen.
I am looking at any organized market, and my trading system tells me that, at a certain moment, there is a 60% chance that the price will go up. This means that if I am going to participate, I will do so by buying because I expect higher prices in the future. But in fact at that moment the probability that the price will not go up is 40%. Nothing negligible.
The first step is to assume that uncertainty. We move based on probabilities and put them in our favor, but we know that we cannot predict something that does not yet exist and, in the same way that I cannot know the result of the flip of a coin that I have not yet taken out of my pocket, I cannot know if the price will increase or decrease.
To make money in the markets in a systematic and consistent way, what I need is to act supported by an advantage, by a “edge“. This advantage will make me participate by putting the probability of winning in my favor, but When operating with probabilities I will have to cover myself in case the result is not favorable to me.
For this reason it is essential adequately manage risk. The idea is not to commit too high a part of my capital in a single operation. For example, if I have a 60% chance of winning and a 40% chance of losing, and I commit all my capital to one trade and it turns out to be a loser, I am out of the market and unable to trade again. I will be “broken”. Even if I have a system that puts the odds of winning in my favor, I will not be able to take advantage of it if I do not have capital with which to continue operating. If instead of committing all my capital, I commit half, and lose that trade, I still have another opportunity to trade again. If instead of that, I divide my capital into ten parts, I would have to chain ten negative operations in a row, to stay out of the market. The general rule is commit a percentage of less than 2% of our capital in each individual operation. In this way we make sure that we are in the market a sufficiently large number of times and, due to the operation of a system based on probabilities, we need a large sample for a certain probability to be expressed.
Imagine that you flip a coin ten times. If it is well balanced, you know that you have a 50% chance of getting heads in one toss and a 50% chance of getting tails… That means that, in ten tosses, you expect to get five heads and five tails… But, can it be that 7 heads and 3 tails come up? Yes, in fact it is relatively easy for it to happen. Take the test if you want and you will see. So what has gone wrong? Nothing. The probability is still 50% on each individual toss, but you need a large enough series of tosses for that probability to be expressed consistently. If instead of 10 throws you make 100, you will see that it is much easier for you to end up with half heads and half tails.
Applied to trading, this means that, when operating based on a probability, you need to be able to take a large enough number of trades for your advantage over the markets to appear. It is not enough for you to take ten operations. And to be able to do it, it is necessary that what you commit in each operation is a very small part of your capital. If it were too big you could be out of the market before the odds “came in”. Hence the general recommendation not to commit more than 2%. In that case, you would have to chain fifty consecutive negative trades to get completely out of the market.
So, if what you want is to ensure the reward that your system can give you, it is essential that you be very strict with your Money Management and risk management policy and limit your degree of exposure.