Do you know why money management is so important in Trading?
This section of the money management is one of the most important sections you will read about trading. Why is it important? Well, we’re in the business of making money, and in order to make money, we have to learn how to manage it. Ironically, this is one of the most neglected areas in trading. Many traders are so eager to get right into trading that they don’t pay attention to their trading account. They simply determine how much they can lose on a single trade and automatically hit the open position button.
when you do trading without money management rules, in fact closer to losing than winning. You are not seeing the long-term return on your investment. Rather, you are only looking for the “jackpot or the jackpot”. Money management rules not only protect you, but will make you very profitable in the long run. If you don’t believe me, and think “gambling” is the way to get rich, then consider this example:
People go to Vegas all the time to gamble their money hoping to hit the jackpot, and in fact, a lot of people do. So how in the world do casinos keep making money if so many people are hitting the jackpots? The answer is that as long as people win jackpots, in the long run, casinos remain profitable because they take money from people who don’t win. That’s where the phrase “the house always wins” comes from.
The truth is that casinos are statistically very rich. They know that in the long run, they are going to be the ones making the money, not the players. Even if someone jackpot wins the $100,000 slots jackpot, the casinos know that there will be 100 more gamblers who will NOT win the jackpot, and that the money will go right back into their pockets.
This is a classic example of how statisticians make money at the expense of punters. Even though they both lose money, the statistician, or the casino in this case, knows how to control their losses. Basically, it’s about how to manage money. If you learn to control your losses, you will have the possibility of being profitable.
Drawdown and Maximum Loss Series in Trading
We already know that money management will make us money in the long run, but now we would like to show you the other side of things. What would happen if you didn’t use the money management rules?
Consider this example:
Let’s say you have $100,000 and you lose $50,000. What percentage of your account have you lost? The answer is 50%. Pretty simple. Now, what percentage of that $50,000 do you have to make to get back to $100,000? It’s not 50%, you have to make 100% of your $50,000 again to get back to your original amount of $100,000. This is called a drawdown or losing series.. For this example, we have had a
drawdown or a losing series of 50%.
The reason for this simple example is that it is very easy to lose money and much harder to get it back. We know you’re thinking, “I’m not going to lose 50% of my account on one trade.” Well, in our courses we are going to teach you not to. Rather the complete opposite.
In trading, we are always looking for an edge. That is the reason why traders develop their systems. A trading system that is 70% profitable sounds great to have, in fact at Traders Business School we are going to teach you how to achieve that reliability. But just because their trading system is 70% profitable, does that mean that for every 100 trades you make, you will win 7 out of 10?
Not necessarily! How do you know that 70 of the 100 trades will be winners? The answer is that you don’t know. You could lose the first 30 trades in a row and win the rest of the 70. That would still give you a 70% return on your system, but have you ever wondered, “Could you still be in the game if you lost 30 trades in a row?”
This is the reason why money management is so important. No matter what system you use, it is very likely that you will have a losing streak. Even professional poker players who make their living through poker go through horrible losing streaks, yet they are still profitable in the end.
This is what we should do as a trader. Only a small percentage of your trading account risk so you can survive losing streaks. Remember that if you strictly practice money management rules, you will become a casino (in the above example) and in the long run, you will “always win”.
Let me show you what happens when you use money management correctly and when you don’t.
Don’t even lose your shirt
This is a simple example that will show you the difference between risking a small percentage of your capital compared to risking a larger percentage.
You can see that there is a big difference between the risk of 2% of your account compared to 10% of your account in a single trade. If you were on a losing streak and lost only 19 trades in a row, you would only have $3,002 left of the $20,000 you had initially, due to the 10% risk on each trade. So you would have lost more than 85% of your account! If you risked only 2% per trade, you would still have $13,903 which is only a 30% loss of your total account.
You can see that the more you lose, the more difficult it is to get back the original amount. This is the most important reason you should always keep in mind when protecting your account.
So, I hope it’s stuck in your head, that you should only risk a small percentage of your account risk on each trade. So that you can survive long losing streaks, and also to avoid a big drawdown on your account. Remember, you must always be the casino… NOT the gambler!
Summary of Money Management
The drawdown or series of losses is a reality and it will happen to you at some point. The less you risk on a trade, the lower your maximum drawdown or maximum loss series will be.
The more you lose in your account, the harder it is to break even or breakeven. Trade only a small percentage of your account. The smaller it is, the better it will be. 3% or less is recommended.
It is convenient to trade when you have a higher risk-reward ratio. The higher the proportion or ratio, the fewer times you will hit.
Sounds interesting to you, right? Keep learning trading with DTP with upcoming articles on our Blog.