As you know money doesn't grow in trees. One of the biggest advantages we have as individual investors is our ability to go to cash when the market is going down.
In the book Market Wizards Jack Schwager interviews many successful traders. They all have different systems and strategies. Some trade based on fundamentals while others rely on price action and charts. The one thing they all have in common is that they all protect their capital at all costs.
But how do you do this?
In order to protect your capital, you should always have a plan and know the following before you enter a trade.
- When to get in
- When to get out
- How much to buy
This is called money management and is one of the most important things in trading. The details will vary depending a person's personality and strategy and fall outside the scope of this blog post. But if you want to know more about proper money management I recommend you read the book Trade Your Way to Financial Freedom by Van K. Tharp (also featured in the Market Wizards book).
Instead I prefer to show you some examples...
Let's assume you have a strategy that has a 60% probability of winning (some of the best traders in the world have made millions with strategies that have 30% probability of winning).
Let's also assume that each trade has a 2:1 win/loss ratio. That means that for every dollar you risk you'll get $2 in return.
The problem is that even though you know that the probability of winning is 60%, you really don't know the order of your winners or losers. The following scenario is a possibility:
L, L, L, L, W, W, W, W, W, W
In this case you have the first four losses in a row followed by 6 wins in a row. This is a matter of when no if. Things like this will happen more often than you think.
Let's run two possible scenarios to show you how it works:
You risk 25% of your capital on each trade.
-25% + -25% + -25% + -25% = 100% LOSS
At this point you have four losses of -25% and you lost all your capital. You just've just blown up your account and you can kiss your trading career goodbye.
You risk 1% of your capital on each trade.
-1% + -1% + -1% + -1% + 2% + 2% + 2% + 2% + 2% + 2% = 4% PROFIT
In this case you ended up with a small profit. The important thing is that you lived to trade another day. Like Ed Seykota said in the book Market Wizards "There are old traders and there are bold traders, but there are very few old, bold traders."
Protecting your capital should be your number one rule always. It's even more important to follow this practice during your learning process.
You're not convinced yet?
Can you see yourself having 10 losses in a row? If you trade long enough it will happen. It's just a matter of time. Can you recover from losing 50% of your capital? Did you know that recovering from a 50% loss requires that you make a 100% gain just to breakeven? Do you know anybody that can make a 100% gain consistently? I don't! The best traders in the world are considered the best when they make 30% a year.
The following table shows how much it takes to recover from losses at different levels.
Before I finish this post I want to leave you with this. Warren Buffet who is called by many the greatest investor that ever lived has suffered two 50% losses in the last 20 years. Can you go to sleep at night knowing that you're 50% poorer? I know I can't... and for this reason I'd rather not put myself in this position.
Remember, the number one rule of trading is to protect your capital at all costs.