Do you dislike mathematics? The majority of traders also do not like it much. No doubt, everyone likes to calculate the profit made in trading, however, arithmetical operations as such do not bring much delight.
Unfortunately, negative financial consequences are inevitable for those traders who do not know how to apply mathematics to trading in the financial markets. If traders do not initially approach trading from the position of ‘dry numbers’ they are doomed to lose their trading capital even without being aware of the fact.
In this article:
- Start with arithmetics.
- When a sequence of small losses carries a threat?
- Is a trailing stop that good?
- Make risk management the main priority.
Start with arithmetics
Let’s have a look at the simplest arithmetics which all traders should know. If you take 10% of gold from a barrel full of gold and then put back 10% of the gold remained in the barrel, would the barrel be as full as it was in the beginning? If your answer is ‘yes’, then you belong to the majority of retail traders and if you continue to trade this way you will lose your trading capital soon.
This is a direct way to bankruptcy since you will have only 99% of the initial volume of gold:
100% – 10% = 90%
90% x 10% = 9%
90% + 9% = 99%
You’ve just lost 1% of gold from your barrel although you expected to come back to the breakeven level. Trading for the sake of making profit pushes the majority of unsuspecting retail traders to a bigger risk than they could have assumed. They didn’t get benefit from the mathematical classes at the elementary school that is why they unintentionally but constantly expose their trading capitals to such losses.
When a sequence of small losses carries a threat?
Do you see yourself as a trader only? If ‘yes’, perhaps you make a big mistake which might result in a fast trading career termination. If you want to achieve long-term success in trading, you will need to master the profession of risk management.
Before executing a trade, it is very important to have a plan for managing its risks, especially for the situation when the market moves against you. It is also important to clearly understand what actions should be undertaken for bringing the trading capital to the breakeven level. For example, you will need 12% of profit to liquidate consequences of 10% of loss and 25% of profit to recover 20% of loss of your trading capital. Have you ever lost 50% of your trading capital in one trade? In such a case you would need to make more than 100% gain on the remaining funds to recoup losses. Understanding of this mechanism is a must for surviving in the financial market.
Due to the recommendations of professional traders it is very easy to focus your attention on the maximally allowable level of losses and still keep in mind the necessary level of income, which would allow you to come back to the breakeven level. Making such a mistake you would continue to make minor losses until they become a huge snowball, which threatens to crush your trading capital.
Is a trailing stop that good?
The trailing stop is the most widespread algorithm of stop loss management used by retail traders. Trailing stop allows automatic trailing of the movement of the asset price by a stop loss if the price moves in the profitable direction. In the event the asset price starts to move in the loss-making direction, the trailing stop algorithm doesn’t produce any action leaving the stop loss where it was.
The trailing stop gives traders a possibility to protect the accumulated profit against an unforeseeable negative development of the market situation and acts more efficiently in the event of powerful price movements in the profitable direction. Nevertheless, the problem of the trailing stop is that the price needs freedom in the process of development. Otherwise, the trades of a trader will be always closed by stop losses since nobody yet has managed to calculate the size of the ideal trailing stop under ever changing market conditions.
So, could it be arranged in such a way so that a trade would be able to ‘breathe’ and a trader would manage to observe the risk management rules? Here’s one very simple and efficient technique which allows to achieve the desired goal. Some professional traders that trade during a day or prefer the middle-term trading split a trade into several (usually 2-3) parts.
For example, splitting a trade into 2 parts allows to close the first part when the price reaches the first goal of a take profit. There is no need to set an ambitious goal for the first part since its task is to take away the risk from the whole trade bringing a profit in the amount of a stop loss. Whereby the second part of the trade will continue to ‘work’. Since the risk has already been taken away from the trade, you have several variants of actions at your disposal: you can transmit the second part of the trade into the breakeven, moving the stop loss to the level of opening the trade or leave the stop loss where it was allowing the trade to ‘breathe freely’. In addition, both these variants allow to significantly reduce the psychological load.
A trade, which is split into 3 parts, differs only by the fact that its second and third parts continue to stay in the market after the take profit goals are achieved, while the goal of the first part stays the same – to take away the risks from the whole trade.
This rather simple but efficient approach to risk management could compete with the trailing stop technique and become the key to the success of your trading. By splitting your trade into several parts you receive a small but stable income from each part of an open trade maintaining control over the risks.
Make risk management the main priority
Professional traders do not allow their passion for trading to interfere with their risk management decisions and they know how to maintain control over the developing situation. Their trading decisions are based on dry numbers rather than emotions. In order to achieve success in trading in the financial markets, retail traders need to learn how to close loss-making trades in cold blood and allow profit-making trades to develop further.
It’s easy to yield to excessive emotional excitement when the market moves along or against you. That is why professional traders always rely on dry numbers of risk management. Several simple methods of risk management described in this article will allow you to avoid transformation of profit-making trades into loss-making ones and also will facilitate to cold-blooded closure of loss-making trades.
Start to use risk management when opening every next trade in order to decrease losses and protect the accumulated profit. As a result, instead of a half-empty barrel with gold at the end of a trading day, you will need a barrel of a bigger size for ‘carrying away’ all gold made.