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Fact: If you take three traders with the exact same abilities and trading talent and pit them against each other, on average only one of the traders will survive. It doesn’t matter if a guy is playing poker with his mates or they are trading together at a coffee shop, the last-man standing will ALWAYS be the guy who managed his bank roll properly.
This article is going to show you how to not only be the “last man standing”, but to be a disciplined winner and hopefully come away with a larger bank roll than you started with. Today, we are going to talk about the capital management “secrets” that will give you the edge over any other trader in the room or your mates at the poker table, so pack your cigars, because if you manage your capital properly you might just walk away a winner next week 🙂
As a trader, if you really want to have a chance at long-term success, you need to learn VERY quickly that your mental energy must be focused on the trading variables that you CAN control. Obviously, we cannot control the market or make it do what we want (although certainly some traders act as if they can), but we can genuinely control most other aspects of trading; 1. Trade entries, 2. Capital preservation and money management, and 3. Our exits…these are all things we DO have control over.
The KEY point there is capital preservation and money management; properly controlling the amount of money you risk per trade (your leverage and exposure to the market) is the primary thing that will make or break you as a trader; in fact, it will decide the fate of your entire trading career. Any professional trader knows that capital preservation is the most important part of their day to day routine as a market professional, this can also be called “playing defense” in the market.
Great traders and fund managers think about how much they could lose before thinking about how much they can win; this is essentially the OPPOSITE of a gambler’s mentality. Gamblers suffer from an uncontrollable mental sickness whereby they focus almost entirely on how much money they could win with almost no regard for losses, this is borderline psychopathic behavior. Unfortunately, this behavior is also very common for many beginning and struggling traders.
I’m sure you’ve heard of some of the huge hedge fund blow-ups that have occurred in recent years. The two primary causes for these have been fraud and excess leverage. Excessive leverage can also be called “irresponsible use of risk capital”, aka NOT practicing proper capital preservation.
As Scott C. Johnston points out in his popular blog “The Naked Dollar”, many prominent hedge fund managers and traders have blown-up hundred-million-dollar portfolios because they did not manage their capital properly. It only takes one hot-head “young-gun” trader to think he is “sure” of something to blow-up a huge fund by taking an extremely over-leveraged bet on some company or some news event.
As I alluded to in the opening paragraph, you can take two traders or investors with the same amount of skill and trading knowledge and one will achieve long-term success while the other continuously loses money and blows up trading accounts. The difference between the two traders is that only one of them may have the mental abilities to manage risk, plan for losses, manage trades and execute capital management correctly and consistently (meaning with discipline over time). Thus, a good trader is truly defined by his or her ability to manage risk and control their exposure to the market…not by their ability to find trades or analyze the markets, contrary to popular belief.
SOME OF THE BEST TRADERS WITH THE BEST TALENT WILL ALWAYS BE NOBODIES, they will always be losers, and they will never make the headlines, because they completely lack mental discipline or skills with capital/portfolio management, and that is where it counts. So heed this advice and listen up…it’s one thing to find a good strategy, it’s another to stay in the game long enough to see the fruits of the trading method; if your capital management and risk control sucks, you’re going to be a loser, it’s pure math, plain and simple.
I know why many traders don’t focus enough on capital preservation and risk management: because they mistakenly think it’s not “fun” or “exciting”, but that’s only because they aren’t thinking about it right or they don’t fully understand how powerful it is.
You see, the KEY to making money over the long-term in the markets is simply staying in the game. You need to preserve your capital good enough so that you stay in the game long enough to see your trading strategy play out and reward you.
The only way to make consistent money as a trader is to have small losses (because you will have losses so better to keep them small) and a few big winners in between. It seems simple, but if you can’t do that, you can’t make money. Now, the hard part in all of this is having the mental state of mind to manage capital properly on a per-trade basis, one must consider dollars risked on the trade and also the leverage used, one must also calculate if this risk is justified but not get too emotional about it. You should always have a max dollar loss per trade pre-planned, but you may risk less than that amount obviously, it all depends on how confident you are in the setup. In essence, you need to have a mental “obsession” with capital preservation, and drop your obsession about rewards and profits. Ironically, if you can do this, you will then start to see the rewards that you were so obsessed with before.
Visual Example : In the example below, let’s look at how proper capital preservation and risk management can allow you to stay in the game long enough to see your equity curve increase consistently over time. Notice how this trader has made ‘lots of very small losses’ and those losses are ‘consistently the same value’. We can also note this trader has the ‘occasional big winner’. It’s hard to believe this trader has achieved a profit with a very low strike rate of just over 20%. It’s easy to see that over time, this trader is likely to make money or at the very least break even. Let this example serve as wake up call to those of you who don’t practice disciplined capital preservation. Study these examples below and go out and start practicing it in the real world.
The key points to take away from the above graphs are that you should have a max dollar amount you will let yourself lose on any one trade, and you must not deviate from that threshold. Do not under ANY circumstances over-leverage or risk too much per trade; the market will ALWAYS be there tomorrow, so ignore the temptation to “go all in”.
However, that said, some trades you can go in a little harder on than others, but the key is that you stay under your overall per-trade dollar risk amount. So, if as in the example above, your per-trade risk threshold is $100, then you can risk any amount on a trade from 1 to 100 dollars. Some trades you may decide to risk less than $100 on, some you might want to use the full $100…this is where discretion and your ability to analyze and gauge the market comes into play, but the key is that you DO have that “cut off” point where you KNOW you will never lose more than a certain dollar amount. This is really the “key” take away point of this whole article.
The best traders cut their losses and they get the hell out when they know they are wrong, and they NEVER put their portfolio, their major assets or their shareholder’s assets at major risk if they get a trade wrong. They plan ahead obsessively and they always know the “worst case scenario” for any trade or investment. These are the traders, investors and fund managers that stand the test of time and experience success while the others blow-up accounts and fall to the way side.
As far as HOW you actually preserve your capital, it mainly involves knowing how much you are emotionally OK with losing PER TRADE and understanding position sizing and risk reward. I won’t get into that today because I’ve written other articles on it that you can check out. See my article on risk reward and position sizing for more.
Whilst sound capital and risk management is certainly the “key” to success in the markets, combining these money management skills with an effective trading strategy will give you an extremely potent edge in the market. Combining my price action strategies with sound capital preservation and risk management skills has enabled me to stay in the game for 12 years. Of all the traders I know and have met, the one thing they always describe as their “secret weapon” and the reason for their success, is focusing on capital preservation; keep losses consistently below a certain dollar threshold and secure profits and let them run when you can. Capital preservation and risk management is your most definable edge in the market, and it’s an edge you have full control over, so don’t take it for granted or abuse it. Your other genuine edge needs to be an effective trading strategy like price action.
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