fbpx

Risk management, the ultimate trading edge

Risk management, the ultimate trading edge

We all know that risk management is the key to earning a steadier income from trading.

Don’t we?

Ok, most of us know.

Statistically, there are still a few of you out there—maybe riding the wave of some crazy month-long winning streak and drinking champagne out of your shoes—who are telling all your friends that managing risk is for chumps.

Fair enough. We’ve heard this before.

 

We all know that risk management is the key to earning a steadier income from trading.

 

That’s why, this week, we’re going to look at what actually happens when you don’t have any risk management strategy in place. If that sounds ominous, it is. Trading without managing risk is scary.

If, by the end of this blog, we haven’t convinced you that this is the case, and you’re still drinking champagne out of your shoes a month from now, let’s talk. We just might be able to get you a book deal.

 

Drawdowns explained

Ok, let’s say you have $100,000 in your account and you lose $50,000. You don’t need to run for your calculator to see that you’ve just lost 50% of your bankroll.

This is what we call a drawdown.

In the barest terms, a drawdown is the difference between a high point and the next low point in your trading account balance. Calculating drawdown is simple enough. Just find a relative peak and a relative trough in capital. The difference is your drawdown.

 

 

Losing any money is psychologically rough. But drawdowns are natural. They’re actually one of the operating costs of maintaining a healthy account. We’ll see why below.

But—and this is a very big but—our 50% drawdown from the graph is not very healthy. Just to break even on your reduced equity position, you’d need a 100% return on your reduced capital stake.

 

Losing any money is psychologically rough. But drawdowns are natural.

 

Any time you dig yourself into a hole like that, it’s usually because you didn’t put a risk management plan in place.

 

The reality of losing streaks

 

 

It’s not a secret. If you’re a trader, you’re always looking for an edge. It’s in our trading DNA to seek out competitive advantages.

The problem is, edges can be deceptive.

Here’s what I’m talking about.

Take a trading system that’s 70% profitable. It might sound like a very good edge to have. But just because your trading system is 70% profitable doesn’t mean that you’re winning 7 out of every 10 times you trade.

I mean, theoretically, you could lose the first 30 trades in a row and then win the next 70. That would still give you a trading system that’s 70% profitable. But that doesn’t even really matter.

The critical question to ask is: “Would you be able to stay in the game if you lost 30 trades in a row?”

The answer is: “You might. If you were sensible with your bankroll.”

 

If you’re a trader, you’re always looking for an edge. It’s in our trading DNA to seek out competitive advantages.

 

This is where risk management enters the equation and why it’s so important. No matter what system you use, you will eventually experience a losing streak. You may not lose 30 times in a row, but you’re going to lose.

Even successful pro poker players have horrible losing streaks, and yet they still end up making a comfortable living playing cards. Why?

Simple. Professional poker players aren’t huge risk takers. It’s true. And because they understand and respect the basic principles of risk management, they also know that the cold hard statistics say they can’t win every tournament they play.

That’s why they never go into tournaments thinking they’re invincible.

Instead, they play like they’re going to lose every hand, and only risk a small percentage of their total bankroll so that they can survive when they do lose.

Make sense now?

Good, because if you want to be a successful trader, you need to do the same.

 

Drawdowns are part of trading too

The key to trading success is no secret. You need to have a trading plan that lets you stay in the game even after you take a big hit. There’s no way to do that without setting risk management rules.

Once you realize that risk management is your friend, and as long as you never risk more than a small percentage of your “trading bankroll”, you’ll always beat the house in the long run.

So, have you put your shoes back on your feet and the champagne back in the fridge? Good. Join us next week and we’ll look at how to design an actual risk management strategy that works.

 


Sign up to demo Tekton and learn how to make faster, easier, better trades in minutes.

Fill in the form to set up your demo trading account instantly.

First Name

Email Address

Password

By using this form you agree with the storage and handling of your data by this website.
No Comments

Sorry, the comment form is closed at this time.