Trading Risk

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Every trader/investor must guard himself against drawdowns, which refer to the percentage drop in his account size after one losing trade or consecutive losing trades.

For example, imagine that after losing a few trades in a row, your $20,000 account is reduced to $12,000; that would be a drawdown of 8,000/20,000 = 40%.

If I were to ask some new traders, "In order to be back up to $20,000, what percentage return do you need togenerate?"

Many would answer, "Since I lost 40%, I have to make back 40%!"

This couldn't be more wrong! Note that after losing 40%, the trader now starts with a lower base, i.e. to undo the $8,000 loss, the return he needs to generate is 8,000/12,000 = 66.6%!

The more severe the drawdown, the harder it becomes to undo the damage, as shown in the numbers below.

Drawdown % %Required to get back to break even
10% 11.1%
20% 25%
30% 42.8%
40% 66.6%
50% 100%
60% 150%
70% 233.3%
80% 400%
90% 900%

That is why all professional money managers only risk 1-2% per trade. It's because no matter how good your trading system is at some point it is a statistical fact you will have 10 losers in a row.

Based on risking only 1-2% per trade this is only a 10-20% drawdown and easily recovered. 99% of the hype trading and investing courses in existence don't say or do this. They say risk 5-10% per trade. It is wrong and will cause you serious financial pain if you follow their advice.

Many of them also use arbitrary stop loss advice. For example they say, "Place your stop at $100.10 because that is on the other side of a major support or resistance, trendline, MA, etc."

This makes your risk based on the size of the stop. That is also wrong because the risk can be too large and it's not the same risk on each trade.

Others reverse this and say risk only 2% total period and let that determine your stop. This is also wrong and will hurt you because it is important to have the correct technical stop.

The answer is to do both. Use a % and technical stop together. It works like this. Let's say the technical stop is $100.10, but based on your entry price that is a 3% risk. Since your plan calls for a 2% risk you simply lower the number of shares you are trading.

This lets you stay within your 2% risk and have the correct technical stop. This is exactly what most professional money mangers do. I know because I used to trade 50 million at a time and risk controls with correct technical stops is the number one priority.

Some say that this will lower their profits because of trading fewer shares. So what? Study the numbers above again. You know the old quote, "More risk equals more reward." Well it's not always true. Sometimes more risk equals more risk! If you lose your money you have no chance to make a profit. Even losing 50% is disastrous because you would then need to make 100% to get back to even.

Like Warren Buffet says, there are only two rules in investing.

Rule #1: Don't lose money.

Rule #2: Don't forget rule #1.

I'd like to add a third rule. Correct money management and position sizing must be mastered to insure your long term success.

The good news is that it is easy to have correct money management and position sizing. I just explained how to use a combo of a % stop and a technical stop.

Your system of entries, stops and profit taking is only half of your key to success. The other half is money management. If you get this part wrong you will lose your account every time regardless of how good your system is.

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