Rules you should follow
4 January 2023
Personal development
4 January 2023
... Stairs up and the elevator down. Indeed, you can lose money very quickly (elevator) but to recover it you need much more time (stairs). This concept is one of the first things you learn about trading. If, for example, you lose half of your equity, In order to recover it you have to double your remaining money.
If you look at Table below, you can understand the meaning, in practice, of a heavy loss.
As the percentage loss of initial capital increases, the required performance to restore your capital back also increases exponentially. So, it is evident that losing 50% of your equity means that you have to get 100% performance in your remaining capital if you want to restore the initial capital.
Therefore, you have to establish a maximum sustainable loss. That is, you have to ask yourself: If all the positions should hit the stop-loss at the same time, what would I lose? Will this loss still enable me to work with my trading account the next day? And most of all, do I gain the opportunity to make a human profit, one which restores back my initial capital? This concept is essential and fundamental to the survival of all traders.
Successful traders are those who have learned this lesson. For them, risk management is something that is truly fundamental. In the figure below, you can see the above table, but in the form of a graph.
As you can see from the graph when you lose money, you have an ever-smaller remaining capital. In this way, you increasingly reduce your ability to earn, because this forces you to perform better each time. And once you’ve wiped out all your money....it is game over.
Although it may seem absurd, the first thing you need to look at is not how much money you can earn, but how much money you could potentially lose. So, always ask yourself: if this trade hits the stop-loss, will I still be able to work in the next few days, and most importantly, will I still be able to work effectively?
Returning to the psychological aspects, I know very well how the human mind works since I made the same mistake myself. It happens when you focus on how much you could earn, ignoring, instead, how much you could lose. When you approach trading, you start rubbing your hands and thinking: “who knows how much money I could make today, and in the coming months.”
It is true that trading is about earning money and increasing capital, but first of all, you should always focus on protecting your money. So, I recommend you define this aspect before clicking on “buy” or “sell,” and never accept any losses that your trading account cannot support.
At the beginning of my business as a trader, when my trading account was not high, I was faced with operations that required too high a margin, up to $ 4,000/$ 5,000. And it was evident that for these trades, I had to insert a stop-loss that was not overly tight, yet, this was not in line with my money management. Those trades did not have a sustainable loss percentage, so what did I do? Simple, I did not make those operations.
After this, you should not look at that operation and think, “man, that trade would have given me such a great profit.” Doing this means making an emotionally troubling mistake. You did well: you could not afford to make that operation so you didn’t. Stop.
In everything you do, you always need to be disciplined, because it is only by following precise rules that you can avoid making mistakes. Do not be sorry if an operation you could not afford to make could have earned you money. In the same way that you studied that trade, you also have to learn to forget it and move on.
To conclude, I give you here the formula you can use to calculate the performance required to recover a percentage loss, bringing us back to the table at the beginning of the chapter. It is as follows:
R = [100 / (100 - P)] * P
Where: R = Required performance, P = Percentage loss of initial capital.
… Stairs up and the elevator down. Indeed, you can lose money very quickly (elevator) but to recover it you need much more time (stairs). This concept is one of the first things you learn about trading. If, for
I am a macroeconomic and financial analyst with over 30 years’ experience, including two years as a fund manager. I specialise in currencies and commodities, and I am the author of several successful books on trading, macroeconomics, and financial markets.
