When I first started trading, all I could think about was how many winners I had to hit in order to bank a million dollars.
I completely ignored the fact that trading is risky. So I overleveraged my account. I didn’t size my positions according to a proper stop-loss, either, because I didn’t have one.
My strategy for exiting trades was simple: if the pain became too much to endure, get out!
As you can imagine, this resulted in more than one blown account.
And my story isn’t unusual. Many traders go through this process. Most end up quitting, thinking the game is rigged and there’s no way to win.
But this isn’t true at all. Trading can be both enjoyable and profitable, so long as it’s done right. But how do you know if you’re doing it right… especially when you’re on a losing streak?
It comes down to one basic, but often overlooked, philosophy…
I’ll tell you what that philosophy is today. And I’ll give you three simple tips that can help you find your edge in the markets.
The Three-Legged Stool of Trading
As a trader, your number one responsibility is to preserve your capital. It is NOT to make sky-high returns.
This philosophy is not particularly exciting, which is why many traders ignore it…. with catastrophic results.
It helps if you think of trading as a three-legged stool.
The first leg is your methodology for analyzing the markets and finding trade setups. The second leg is your methodology for risk management. The third leg is your trading psychology.
I believe the first leg, while important, will ultimately have the smallest impact on your portfolio returns. The second and third legs of that stool are crucial.
That’s why, in my last article for Money Trends, I discussed the importance of having a strong risk-to-reward ratio on your trades.
I showed you how, with the right risk parameters, a trader with a 50% win rate can outperform a trader with a 90% win rate. This is only possible, however, if the trader with the 50% win rate can stay alive long enough to hit some winning trades.
I know, I know. This part of trading isn’t as exciting as showing a really cool trade setup with massive upside. But it is far more important.
Let’s look at the math behind our numbers. For instance, our trader with the 50% win rate will at some point go through a 16-trade streak. That streak could be a winning streak, or it could be a losing one.
The thought of losing 16 trades in a row is horrifying for any trader. But even a trader with a 60% win rate will go through a streak of 12 winning or losing trades at some point.
If you plan on trading for any significant length of time, you will go through this streak. And if you’re hoping it will be a winning streak… then you’re gambling.
I’ve been there…
Over my professional trading career, there have been times when I’ve lost 8 or 9 trades in a row.
If I didn’t have a rock-solid risk management strategy, odds are I would have gone through a devastating drawdown that would have been nearly impossible to come back from.
Which begs the question: How do you find the risk management strategy that’s right for you?
Three Steps to Finding a Winning Strategy
Every trader’s exact risk management strategy is different, but one thing is for sure…
You should protect your downside… and always think first about how much of your account you could lose on a trade before sizing up the potential rewards.
How do you do that? Here are my top three tips:
Keep your positions small and your targeted risk-to-reward ratio high. Nobody puts on a trade thinking that it is not going to turn out well. Every time you pull the trigger, it’s because you think you have a winner on your hands.
Remember that and plan accordingly. By keeping your positions small and your targeted risk-to-reward high, you don’t need to take outsized positions to achieve strong returns over time.
If you take a position that is 0.25% of your net account value and you hit a 3:1 winner, you just returned 0.75% on your account. Not bad at all.
Have rules for how much net exposure your account can have at any time. It is all well and good to commit to taking small positions. But if you have several small positions open at once, they could add up to a significant exposure.
Don’t throw out your strategy and go shopping for a new one just because you’ve lost a few trades in a row. Remember, a trader with a 50% win rate will eventually go on a 16-trade streak. The odds of having smaller 4 or 5 trade streaks is much higher.
If you decide your strategy is no good just because you have a few losing trades in a row, you are not allowing your statistical edge to play out.
Bottom line: Losing is a part of trading. What separates the “bad” from the “good” traders is that the good traders set a risk-management plan… and stick to it.
So next time you’re going through a rough patch in the markets, don’t panic. Just remember the three tips above.
Editor, Money Trends
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