Remember, the goal with your trading capital is to keep your losses as small as possible while also making sure that we open a large enough position so we can capitalize on profits as well.

So the question becomes, regarding trading capital, what is a small loss? Well, they’re usually represented as a percentage of your trading float, and studies have been done that suggest you should never risk more than two percent of your trading capital on any trade. However, most pros will tell you that this is way too much. They’ll risk one percent to even as little as a quarter of a percent on any trade.

The idea here though is that no one trade is really going to affect your trading capital either way. I really believe a lot of people don’t actually appreciate how powerful this rule is. To be honest, by simply changing the amount of trading capital you risk, you can turn a system from returning 10 percent to a 100 percent per annum by simply altering this one variable.

Ultimately, by increasing the risk to your trading capital, yes you increase your chance for reward, however, you also end up increasing your draw down as well, and although I recommend you never exceed two percent risk, I do recommend that you do a little bit of testing to understand the importance and the power of changing this one variable. But, let’s look at an example of the two percent rule in action. If we had a trading float that was 20,000 dollars, by setting the two percent rule, we set our maximum loss to our trading capital to be 400 dollars on any one trade.

The beauty of having made such small losses to your trading capital with the two percent rule is that we need a huge string of losses before our entire trading float is eroded. If we had a 20,000 dollar trading float and maximum loss was 400 dollars, we could have a string of 50 losses in a row before we had no more trading capital left.

With most trading systems the chances of getting 50 losses in a row is very, very slim. However, the chances of going broke and losing all your trading capital are even smaller than that because when you implement the two percent rule correctly, that two percent is actually calculated on the current float size.

Initially, two percent of 20,000 dollars of trading capital is 400 dollars. However, if we experienced a loss first off, our trading float would now be worth 19,600 dollars. We calculate two percent of this new value of our trading float, and set this as our maximum loss for our next position. Two percent of 19,600 dollars would be 392 dollars, so you can see the effect each time our maximum loss to our trading capital would shrink.

As the portfolio increases in size, we’re happy to take on more risk to our trading capital as well. I thought I’d play around with a few of the figures just to see what would happen if we had a string of six losses in a row. Our trading float after receiving six losses in a row would have decreased to only 17,717 dollars. That’s after six successive losses, and we’ve only lost 2,283 dollars. Now, that’s managing your risk.

Being such a small component of our trading float makes it much easier to gain back those losses. In this example, we’ve lost a little bit more than ten percent. To gain back a ten percent loss, we’ll need to make 11.1 percent gain to get our trading float just back to break even.

Now, imagine if we didn’t have good money management in place and we had a draw down of over 50 percent. If we have a draw down of 50 percent, we need to make 100 percent return on our remaining trading capital just to reach break even. So, you can begin to see the bigger the draw down the more difficult it is to pull yourself out of that.

Remember, novices risk more than two percent of their trading capital. Now, you know better. Also, if you’re starting out with a small trading float, that’s no excuse for practicing poor money management. Your goal in trading should be trading to survive. If you can survive in trading, the profits will come and your trading capital will increase.

What you need to do is position yourself so that you can endure long strings of losses to your trading capital, so that when the market does turn around, you’re already in the market positioned to capitalize on those moves, and that’s what setting the maximum loss is all about.

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