Are You Allowing Your Capital To Erode Too Much?

(c) Dean Whittingham 2007

I am always reading books about trading, as it is a love of mine (and should be of yours if you are serious about trading) and I'm always looking to improve. Just recently I was reading a book by Van Tharp and another by Dirk TuToit and I caught myself making sub conscious remarks to myself every time I read a line about position sizing and risk.

The theme, which is similar in both books, is about keeping your risk down to around 1-2% of your capital, and that almost all successful traders will say a risk of greater than 3-4% per trade is highly risky. When I ever I read this I was saying to my subconscious, 'der, that's obvious, why do you keep saying it?' and then it dawned upon me. This is a major flaw in a lot of traders trading!

I had forgotten what I was like years ago when I first started out, and it did remind me of how far I've come, but it also gave me the inspiration to write this.

The desire to risk large amounts per trade is there with all traders, young or old, experienced or novices, however what one learns over time is that the big home runs don't contribute to your success, nor do the winning trades. What helps you create a successful trading career is the ability to know that your system will provide you a positive outcome over time.

In order for this to happen one must realize that because any system has losses, those losses must be allowed to occur. If you have a system that you feel provides a 70% win to loss ratio (you have determined this through back-testing, reviewing your past trades and also from trades you miss), obviously 30 out of every 100 trades will lose.

The thing to know here is what are you going to do if you risk 10% in each trade and you happen to get 10 losses in a row? Can that happen? Of course it can, unlikely as it may seem it can still happen. What if you risk 5% per trade? You'll be down to only 59% (assuming you trade 5% of available capital) of your original capital. Now in order for you to make all that money back, you now have to have 11 winning trades in a row!

What makes this whole trading style worse is that psychologically; most can't take a large drawdown.

The point here is that consecutive losses can, do and will occur and your capital needs to be able to absorb them and so do you. The best and only way to do this is to keep your position sizes to the smallest possible amount so your risk is small. Sure, your capital wont grow as quick as it would if you happened to have some winning trades risking 5-10%, but that's not the issue; preservation of you and your capital is.

Over time, you'll learn that compounding your returns, and having the ability to deposit funds periodically into your trading account (treating it like a savings account), will create a scenario where you can risk much less. 1% of $100,000 is far easier to risk and trade than 10% of $10,000. And remember, do you want to create an ideal lifestyle in 5 to 10 years, or do you want to be stuck in the same job for 45 years? Patience will help you create that ideal lifestyle, not hitting home runs.