The Most Important Money Management Rule that Most Traders Forget – Why?

What is the one rule that all professional traders use, but many retail traders forget, or are simply unaware of?

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We all know that the goal of trading is to make money, and as long as you have an edge in the market, you will be profitable in the long-run.

So the next question is, how do you maximize your profitability without blowing up your account?

The answer lies in the 2% money management rule.

Let’s use a hypothetical example where you start betting with $10,000. In this scenario, you have hitrate (winning chance) of 60%, and you either win double of what you bet, or lose the whole sum of what you bet. How much would you bet each time?

If you bet the whole $10,000, you have a 60% chance of doubling your money, but you also have a 40% chance of losing everything. That is exciting for a gambler, but not ideal if you want to remain profitable in the long-run.

What if you split your $10,000 into 2 bets of $5000 each? Your probability of losing 2 bets in a row is only 16% (40%*40%), which means your chances of losing everything is much less. Sounds good? What if you take it one step further, and split your $10,000 into 10 bets of $1000 each? The odds of losing everything drops to just 0.01%.

In trading, the secret of money management is not to focus on making the most money, but rather to ensure that you do not lose your capital.

As Warren Buffet once said, the number one rule of his is to not lose money.

How does this apply to your trading?

According to the 2% rule, when we take a trade, we will only risk 2% of our capital on each trade, meaning for a $10,000 account, we will only be risking $200 per trade, and that is the maximum amount that we can lose for each trade. (Risk is calculated as the difference between the entry price and stoploss price, multiplied by the quantity traded.)

With this 2% money management rule, the only way to lose all your trading capital is to lose 50 times in a row, and the probability of that happening is less than 0.000000000000000001%.

We have most likely heard horror stories of traders blowing up their account, and that is happens when they break this rule. If you stick to this 2% money management rule, it is almost impossible for you to blow up your account, and you will see a marked improvement in your trading results.

And this is what separates the professionals from the average trader.
Which one are you today? 😀

Trading Psychology | The Psychology of the Stoploss – Why is it so Hard?

Many new to trading have the tendency to liquidate positions that show a small profit, yet they keep those positions that show a loss as are unwilling to take a loss, in hope that prices will rebound. Such a counter-intuitive strategy will result in small wins and large losses, but why do people still do it? The new science of behavioral finance psychology may offer an explanation.

 

The Psychology of the Stoploss – Why is it so Hard?

 

1. Disposition Effect

Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. This can be explained by the value function curve, where investors turn more risk-seeking as the stock depreciates. As shown by studies on ex-post returns, it would be more profitable to cut losses fast and let profits run. Hence, investors should treat unrealized losses as a sunk cost, and focus on reducing prospective costs (likelihood of more losses). Unfortunately, irrational hope destroys any edge their analysis provides, thus resulting in an unfair gamble.

2. Loss Aversion / Breakeven Effect

With its roots from prospect theory, this refers to investors’ tendency to strongly prefer avoiding losses to acquiring gains. For loss aversion, investors prefer an uncertain gamble to a certain loss as long as the gamble has the possibility of no loss, even though the expected value of the uncertain loss is lower than the certain loss. For the breakeven effect, investors prefer a gamble that offers the potential of recovering to finish at an aspiration level rather than a certain rate of return.

Some studies suggest that losses are twice as powerful, psychologically, as gains. Hence, investors will cling to the hope (including rationalization) that prices will rebound to their entry price, which they have now established as a reference point. However, this reference point is illogical, since their entry point does not affect the future direction of prices. One question to ask is, “if you don’t have a position now, would you open a new position?”

If prices fall past their stoploss (showing that their analysis was wrong), it means that the odds are now against them. If prices fall but do not hit their stop, and subsequently rises back to breakeven, it actually shows that their initial analysis is still correct (not proven wrong), which means that exiting at breakeven is in fact destroying their winning trades. This will lower their hitrate by causing them to exit winners prematurely.

 

Behavioral Analysis – Value Function Graph

 

How can traders overcome these biases?

Traders should keep mind that trading with an edge will increase their wealth over time, but it is not possible to be right on every trade. The number of times you win or lose doesn’t matter. It is how much you lose when you are wrong and how much you win when you are right that matters. One should also separate decision-making from execution, meaning to “plan the trade” and “trade the plan.” A good way to manage risk is to use a stoploss to limit one’s downside, and pick trades with good R/R (reward:risk ratios) so that one’s winners will be more than their losers. This will allow one to cut their losses fast, and let their winners run.

Is Trading really Risky like Gambling?

At first glance, trading appears to be very similar to why gambling, which is why many people deem it to be intrinsically risky, with the high possibility of huge loss. However, while there are some similarities, there is actually a major difference between these two activities.

Trading and gambling both involve a certain element of luck and skill, as well as probabilities and uncertainties. Both present the opportunity to make huge amounts of money in a short period of time, and vice versa. That is why both pursuits require good money management skills and strong psychology.

Is Trading really Risky like Gambling?

Is Trading really Risky like Gambling?

However, there is one big difference – the edge. Whether you are trading or gambling depends on whether you have the edge. Simply put, this refers to whether probability is on your side. In trading, doing your analysis and taking a calculated risk tilts the probability in your favour, while in gambling, such as in a casino, the odds are always against you.

Before I move on, let me explain the law of large numbers. In statistics, this law states that the larger your sample size (the number of times you trade or gamble), the closer your outcome will be to the expected outcome. If you have the edge, your expected outcome is positive, hence in trading it makes sense to spread out your money over many trades. In gambling, since you do not have the edge, your best bet is to take single large bets, and quit the moment you’re up, but this is also a quick way to lose your capital.

The risk involved is not just the activity itself, but rather the expertise and experience of the person doing it. Professional poker players (who are not gamblers) win because they do not play by luck (gambling), instead they use a system that gives them an edge over other players in the long run. The reason why people lose big in trading is because they take single large bets instead of many small bets, and they trade without a method or system which gives them an edge. This is why position-sizing, capital allocation and risk management are such essential concepts in trading.

Are you making decisions or just guessing?

Are you making decisions or just guessing?

Some people have asked: Is it possible to make money if one’s hitrate is less than 50%? The answer is yes. If one makes more money when one wins as compared to one’s losses when one loses. This is the idea of the reward/risk ratio, which calculates the upside vs. the downside of every trade. In fact, there are quite a few profitable systems that have hitrates of less than 50%.

In conclusion, the greatest risk is not trading or gambling, but rather the player. Emotions, such as greed and hope, tend to cloud better judgment even when one should know better. Most traders tend to see only the upside in stocks, and not the downside, hence they sell quickly once they see a profit, but hold on to losses in hope that these would turn around. This is the main reason why many traders who have the edge are still unable to grow their accounts.