In our last lesson we looked at what one can reasonably expect to earn from their trading over the long term, and how one can avoid the common misconceptions of most traders which ultimately cause them to fail. In this lesson we are going to look at the next step in developing successful money managemeent strategies which is how to manage your losses.
One of the main key’s to successful trading is the preservation of capital. Beyond the obvious point here that if you lose your trading capital then you will be out of the game, is the fact that it takes much more to come back from a loss than it does to take the loss you are trying to come back from.
As an example here lets say you start with $10,000 and loose $5000 from a string of bad trades. That $5000 loss represents a 50% loss on your account which now has $5000 left in it. Now ask yourself this question. What percentage gain will you need to make on the $5000 left in your account in order just to be back to break even (the $10,000 level) on your account? If you have done that correctly you will see that in order to make back the 50% loss you took on your account you will need to make a 100% return or basically be twice as successful in your comeback as you were unsuccessful in your draw down.
It is this concept that is one of the most important to understand in trading, as it underscores the importance of protecting one’s trading capital, as it shows the difficulty of coming back from a loss in relation to the ease of taking a loss. It is also most traders lack of understanding of this concept that causes them to take risks which are way to large and is a major contributor to the high failure rate among traders.