Trading is risk management

Trading = Risk Management. A concept that is far beyond most traders that have not been trained or trained correctly. Most new traders approach the market expecting to make money quick and easy without thinking at all about the risks involved. This is exactly the opposite of what professional traders do. We as traders need to foresee and manage risk, the profit will take care of itself. 
 

THE ONE PERCENT RULE

As a hard rule we will only risk 1% of our account balance on any given trade. No more, no less.

This means that if you are trading a $10,000 account size, the maximum risk you can take on any given trader = 1% of $10,000 = $100.

The protection of your capital, with which you trade with, is your most important job as a trader.  It is a given statistic that 90% of new traders blow up their entire account within the first 90 days of trading (the 90/90 rule). The only reason that this the happening, is because the majority of new traders have not been educated properly and enter the markets with an overwhelming feeling of infatuation. They are blind to all the forces working against them (psychology, experience, position sizing, trade management, random distribution and the law of large numbers etc, etc).

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You might think, well hold on a minute, I don't have $10,000 to fund my account with. I can only afford a $2,000 account. This means that I could only risk $20 per trade? That is exactly what we mean. New traders often make the mistake to not calculate their max risk per trade and for instance decide to risk $200 on their first trade while trading a $2,000 account. There is a fair change their first 5 trades are losses when they first enter the market unexperienced, expecting to make money from the get-go. After five losing trades they lost $1,000 or 50% of their account. Besides the immense psychological effect this will have on a new trader, this also imposes an almost impossible situation to get to the original account size of $2,000. And here's why. 

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To make back the $1,000 or 50% of the account that was lost. This trader now has to gain 100% from the $1,000 that remains from his account balance, only to break even on the account. A nearly impossible job for a new trader. Trading, as you will find out, is a 'emotional negative sum game'. Meaning even if the trader in this example could manage to win his lost $1,000 back and thereby getting his account back to break-even, he would feel disgruntled and burnt out about the whole experience. Although nothing was lost in terms of $ or %, his emotional end-state would not be neutral towards the market or himself. Such a negative emotional state is a dangerous companion to have when trading and will no doubt affect his future trading. 

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Due to the 'random distribution of winners and losers', you will not know in advance if you will be winning of losing the first few trades that you take. As a rule of thumb we need to preserve at least 75% of our account balance, in order not to fall prey to the impossible task of regaining more percentages in losses than can be expected of the strategy we trade. In this case, if we were te lose 25% of our account, we would have to win 33,3% to get our account back to break-even, which is not desirable but not an impossible task.  Below you will find a table detailing how much profit you would need to recover from a certain amount of loss.

STOP-LOSS ORDER

To make sure we never risk more than 1% of our account balance, we put in a stop-loss order when we enter a trade. All this means is that when we open our brokerage account and enter a trade, we know exactly where to go out of the position if price moves against us. For instance we bought the CFD (Contract For Difference - we'll get into that CFD's are later in this masterclass) Silver for $10 and we expect it t o go to at least $12. We know that if price does not rally but declines below $9, our trade idea has been proven wrong and we will exit as soon as price hits $9. Our trading account size is $10,000. So 1% of our trading account equals $100. We enter the market at $10 and are planning to get out the position for al loss if price hits $9, therefore risking just $1 to make $2 or more.

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How many CFD units of Silver could you take knowing all this? The answer is $100 (risk per trade) /$1 (stop loss risk) = 100 CFD units. This is called 'position sizing' and we'll discuss this in great detail further on in this course. The thing I want you to take away from this example is that when we enter the trade on our brokerage platform, we know exactly where to get out for a 1% loss even before we take the trade. The stop-loss order that was filled out in the order screen of our broker, means that our broker will now automatically liquidate the position as soon as Silver hits $9. We don't use mental stops, requiring the trader to physically log into their brokerage software and liquidate the position himself.

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There will be many times that your stop-loss orde gets hit, and price bounces of that level (in our example the $9 level) and go straight to your profit-target. Many times. In fact this will happen so often that you will feel the urge to take off your stop-loss order, to see what price does at this level. Don't ever indulge this self-sabotaging behavior. Many traders (including myself) have done this many times, only to find out that you will lose a lot more than just your 1%, making it even harder to close down the position manually when you are in a 4% or 5% losing position due to not sticking to your rules.

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If price indeed moves into your favor after removing your stop-loss order, eliminating your 1% loss or positionally making you money, is the absolute worst that can happen. You might think that this is good practice and hell it might even work for a couple of times. But then comes along the trade where price does not bounce back and falls steeper than you can imagine, leaving you feel numb and unable to act on your position as you see it fall to -2%, -3%, -5%, -10% in a matter minutes or hours.

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And then, when out of pure frustration and fear of losing a substantial part of your trading account, you find the courage to close of the position for let's say -7%, price bounces back literally that very same minute only to rally back to break even or even further. You want to tare out you hair or throw you laptop through the window at this point, trust me.. I've been there. 

If you ever feel the urge to take off your stop-loss order, you have not comprehended and embrace your probability model (and the law of random distribution and law of large numbers), period. You NEED te revisit this course and read this chapter again and again and do the exercises again and again until you understand these laws. You must 'know' and 'believe' that the outcome of each individual trade has nothing to do with the effectiveness of your strategy or your ability to trade.

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As a rule of thumb, if you ever find yourself 'hoping' for anything that has to do with an open trade, shut the trade down immediately. Hoping is an emotion that will absolutely and without a doubt kill your trading account and your ability to ever become a consistent trader. We do our due diligence before we enter a trade, if all setup criteria have been met we identify where we step out for a loss if the trade does not work out, we fill-out our order form and we enter the trade. During the trade we do not hope or fear. We just trade what we planned before we got into the trade.

It is human trait that we want to be right. It is very difficult for most humans to accept that you can be wrong and still be right. When taking 3-4 losing trades that fit into you trading plan and are part of your strategy, you are still doing your job as a trader as you should be. However you will feel uncomfortable. This is completely normal. As a trader you will have to learn to feel comfortable feeling uncomfortable.

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With experience and in time, and if you can fight all the self-sabotaging urges that will try to manipulate with your plan, you will have experienced for yourself that your trading plan and your probability model are in fact working for you. In time, it will become easier to lose. You will have replaced your old beliefs like "I must be right" or "I hate losing, because that means I was wrong by a news beliefs  like "I trust in my strategy and my plan", "I know that over time I will come out on top, every time". It will take time and self constraint to develop this mindset and set of beliefs, but if you hang in there they will become yours as well.

TAKE-PROFIT ORDER

The opposite from a stop-loss order is a take-profit order (or limit order). Where with a stop-loss order, you'd set a price where you would go out of a position for a 1% loss, with a take-profit order you set a price at which you will get out of a trade for profit. This sounds easy enough right? Much easier to go out of a trade for profit than for a loss.. Wrong. This is where the emotion GREED kicks in.

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In our previous example we entered a trade at $10 and are planning to take profit as soon as price of Silver hits $12. Hence we risk $1 to make $2 per single Silver CFD-unit. In our example we risked $100 as per the 1% rule. As soon as price hits the $12 mark, our position is liquidated by our broker for a nice $200 profit. Normally it will take about a few hours to 3 days on average for such a move to complete. However as soon as the position has been closed for a profit, you will time-and-time again see, that volatility kicks in and before you know it, the price of Silver is now $15 of even $20 after 2-3 more days.

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You will calculate in your head how much money you've left on the table ($800). Although you have just closed down a fantastic trade that you've executed to perfection as part of your trading plan, you still feel very uncomfortable about the whole ordeal. If only you would have held onto the trade for 3 more days.. This will happen to you al lot. More times than not you will feel that you are cutting your winners short. The times that you took profit and price indeed stopped or reversed you will have long forgotten. Only the positions that kept on going are fresh in your mind, and will make you feel uncomfortable and your subconscious brain will do whatever it can to self sabotage your behaviour and break your trading plan.

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So what can you do? The answer: journal your trades and see for yourself that when taking into account all your past trades, you actually had the best average return that was possible. Trading is compromising. You will almost never close a postion down at exactly the point at which price will reverse. This can be a hard pill to swallow for a person that has a deep desire to be a perfectionist or a person that is very greedy. You see your personality plays a huge role in how you will feel and behave as a trader. In this course I will go above and beyond to show you exactly where the pit-falls are and how to avoid them. With examples I will try to simulate those emotional states that don't have any place in trading. After completing this masterclass and trading your real money, you will be able to identify them more easily and hopefully ignore them completely as you build your experience and confidence.