The management of risk is frequently overlooked by traders. It is cited as being a boring subject where complicated formulae are needed to understand and quantify risk. Many traders especially in the modern world of hit-and-run or guerrilla-style trading believe that they can survive by virtue of their skill in being able to get in and out of a position at the click of a mouse. They believe in their own infallibility that “it” won’t happen to them. They won’t get caught holding the position just when the market moves directionally and becomes a career-changing trade.
Analysis from brokerage houses seems to be universal in suggesting that nothing has changed since the days of Benjamin Graham, William Dodd and Richard Schabacker. (These gentlemen were the forerunners of technical analysis from over 80 years ago.) The vast majority end up quitting the trade due to losses.
Human nature tends to operate in herds where we prefer to follow rather than lead. We are creatures of habit and emotion. We are opinionated and quite inflexible in our outlook tending to make statements along the lines of ‘I am right and they cannot see the wood for the trees’. We have a habit of running losses and cutting winners. We live in a world of instant gratification where the winner takes all and the loser is left to cry about if only and would have/should have but of course, did not.
All this is normal if one delves a little bit into psychology. The root cause of most traders’ demise is purely overleverage and undercapitalization. There is a tendency to try to sprint as if running a 100-meter dash rather than understanding that slowly, slowly catching a monkey in a marathon where stamina is vital to complete the course is not just desirable but necessary to survive to carve out a living.
Why traders trade is a valid question. Sometimes the answer is that they enjoy the thrill rather than purely stating that they are running a business to earn a wage and to get to a certain level of profitability whereby a bonus can be paid. In any business, it is about having a plan and being flexible to prevailing fundamental changes. In any business, one has to deal with unforeseen events that might be encountered and it behooves traders to look to the risks and the mitigation of those risks rather than the potential profits.
In an article of this size, it is impossible to cover anything but the basics and understanding your chosen market requires education to ascertain what type of trader you wish to be: Scalper, Swing or Position Trader. Each requires a different set of parameters both in terms of order entry and therefore exit. Additionally, position size is different according to market conditions in that a volatile market across news requires a smaller position for the greater market risk being undertaken whereas during a sideways market at lunchtime larger size can be entered to compensate for the smaller moves.
In simplistic terms let us look at an average scenario of starting with an account with $10k. At this level it is almost impossible not to be over-leveraged but we can adhere to certain rules that are applicable to someone with a million bucks. Take the 10k and multiply by 30% to arrive at 3k. This represents the maximum amount of margin that can be used at any time thereby leaving 70% of the fund available in case the 3k gets eaten up by losses.
Now ascertain the margin that the broker will exercise and on average this is likely to be around 1.5% but is entirely dependent on the ratio of leverage that is offered. EG: an account that is set at 50:1 leverage will have a lower margin requirement versus one that is set at 100:1. Taking the 50:1 conservative level and the calculation is $100,000 / 50 = 2k thus the initial 3k would support a position of 150k investment. However, consider a 1% move in the trade, and 50% of the deposited margin is wiped out.
This is where it becomes important to establish a monetary set of values until the account has been built up and limit losses to a maximum of say 20% of the deposited margin of 3k. IE: 3k * 20% is $600.
Recap:
Account Size $10,000
Available Margin 10,000 * 30% = $3,000
Monetary Stop 3,000 * 20% = $600
Once a stop is activated then reduce trading leverage by 20% until the account regains the amount lost. Once the account has doubled then and only then increase the position size according to the above-mentioned criteria.
This article, written by a highly respected trading professional and a member of global-view.com, reflects the views of the author. This article was published on our site at an earlier date and is being republished.
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