Risk Management Is Everything
Another reason traders lose money is because they don’t know how to manage risk. No matter what you’re trading or investing in, potential reward ALWAYS comes with risk and the bigger the reward, the bigger the risk.
People that buy markets without a plan are just gambling. The vast majority of rookie traders only want to focus on how much money they’re going to make on a trade. But savvy traders think even more about what to do if a trade does NOT work.
Risk management boils down to 3 questions:
1 . Stops – where will you close your trade if it doesn’t do what you expect?
2 . Position size – how much capital are you putting into the trade?
3 . Targets – where will you close part or all of your trade if it does work?
A trader’s goal with risk management is to have a trading strategy that shows a positive expectancy. This means you expect to make money over time, not on every trade.
Let’s look at a quick example:
Assume you’ve taken 10 trades6 profitable trades4 losing tradesYour 6 winners made $10,000 on averageYour 4 losses were $5,000 on average. You would have ended up with a 60% win ratio, and a realized 2:1 reward-to-risk ratio (also knows as “profit factor“).
In other words, you won more trades than you lost AND your average winning trade was larger than your average losing trade. Your total winning trades are +$60,000Your total losing trades are -$20,000Your net profit = $40,000
This means you averaged $4,000 profit per trade even though you only won 60% of your trades. If you know your strategy has a positive expectancy, you can stay confident when you encounter a losing trade.
Unfortunately, most traders are undisciplined and won’t do this. Instead, they’ll panic when they lose a trade and start over-trading to make that money back.
Which leads to a death spiral of bad trading decisions.
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