Sample
#5 - Chapter 23 of 35:
Here is a small sample from this chapter.
“Money
& Risk Management”
Finally we have come to the critical planning stage that I have been
hinting about since page one. There are many ways to be successful in
the markets and many profitable trading strategies. However, in order to
be consistently profitable, you have to learn to adapt when your
strategies no longer work.
The
core component in any successful trading plan is excellent money
management. It’s very important that you treat your trading like a
business and limit your risk so you will have the staying power to be
around for the really big moves.
Let’s face it: There is no trading system capable of being correct 100 percent of the time. At some point, you’re going to lose money on a trade; you must be comfortable with this fact if you already haven’t experienced a loss.
Money management is the tool that is going to save you from losing too much on any one trade and keep you in the game longer until things turn in your favor again.
Many
successful traders agree that money management is a driving principle to
their success in the markets. I finally found my comfort zone once I
started using a disciplined money-management approach and after much
trial and error.
With
smart money management, you can be wrong more often than you are right
still come out ahead in most cases. I will explain how to do that
throughout this section.
Even
if you are already familiar with money-management principles, I believe
I can show new twists and offer a fresh perspective to those guiding
principles. If you are new to the idea of money management, then you are
in for a treat, a whole new way of thinking awaits you.
You
are now entering the realm of a professional trader, where money and
risk management make up the nucleus to a trading plan that goes
hand-in-hand with reading the emotions of others and mastering your own.
What is Money
Management?
Money management is simply a set of rules and guidelines that keeps your risk down to manageable levels. These rules and guidelines need to be in place before you even enter a trade so that your emotions can be controlled while you follow your rules.
The key to not losing everything is a healthy respect for risk and preserving your capital. Your capital is your life blood for trading, and if you don’t treat it like your most important asset, you will lose it.
Rule #1: Protect your capital
You need to think defensively first and then create an offensive strategy that fits within the defensive guidelines. As the old saying goes, “Offense wins games, defense
wins championships.” You need to aggressively protect your capital and
bring the trade to a level where you cannot lose – profits are
secondary.
Once
you reach that point in a trade, your next focus is to aggressively
protect the new capital you have accumulated so far. Continue to manage
the trade, protecting new-found capital until you are stopped out or an
extreme profit target has been met.
This is how you can have a losing record and still remain profitable. No matter how well you spot the setups and add all the criteria for a perfect trade, you will lose some of the time. A perfect 10-point trade can still go against you, and if you risk too much, your account will suffer a huge loss in your account.
That is not protecting your capital! The two things you truly have control over are your money-management principles and your own emotions.
Many successful traders have win ratios between 30 and 50 percent. They aren’t successful because they can predict prices well but because their profitable trades far exceed their losses.
For example, if I have 10 trades with a 3-to-1 risk-to-reward ratio and I win only five times out of those 10 trades, I will still make money. If I make $600 on my winners and limit my losers to $200, I will have five winners’ times $600 for a total of $3000 and five losers for a total of $1000. Total profit would be $2000. This is with a 50/50 win percentage.
You can still be profitable only winning only 30 percent of the time. Here’s an example using the same figures:
3 winners = $1800
7 losers = $1400
Total = +$400
To apply this type of money-management control, adhere to the trading axiom of “Let your profits run and cut your loses short.” This is easier said than done – which is why a detailed plan and rules are necessary to prevent you from doing the exact opposite. Many novice traders (myself included during my early trading days) would find themselves holding on to a losing position, for dear life hoping and praying that someday it’ll at least come back to break even.
Eventually, these traders sell for a huge loss – they let their losses run. These same traders trip over themselves and run to the bank the moment they have a small profit and cut their profits short. Trading this way leads to guaranteed frustration and empty trading accounts.
By having a detailed plan and rules to follow, you effectively put your trading on auto-pilot, eliminating the emotions of fear and greed. That’s only if you follow your rules of course. This is where discipline and mastering your own psychological pitfalls becomes a critical component of your overall plan.
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