Time Crunch Trading

Any discussion of trading must include the topic of risk. It is risk, or rather the misunderstanding and misapplication of it, that most often trips up new traders, preventing them from ever becoming old traders.

As in any other part of life, you have to be prepared to face a negative to be able to achieve a significant positive. We take risks in our lives all the time. We generally do so in a fairly controlled fashion, though, with a degree of surety as to the outcome. Trading should be the same. Unfortunately, it often does not end up being that way.

Risk, in trading parlance, is defined by many people in the markets as the chance of a negative outcome taking place. It is often thought of in terms of losing money on a single trade or position, but it just as well can be applied to the aggregate of a collection of trades – one’s performance over time. Actually, it is the latter idea that should be the one you focus on most.

To be sure, trading involves risk, but as we already stated, you must take risk to gain reward. That is the simple fact. Do you need to take big risks, though, to achieve the big rewards the markets can provide? Not necessarily. While true in general terms that you need to take more risk to achieve higher returns, there is a limit. Taking maximum risk does not directly lead to maximum returns.

Consider this example.

You have a trading methodology with a 90% chance of producing a profit on any given trade. That sounds pretty good, doesn’t it? 

Now let us say that the system produces an average per trade return equal to ten times the risk taken, so if you put 10% of your money in to a trade, you make 100%. That is a 10:1 reward/risk ratio, which is pretty fantastic.

So we have this awesome system which seems guaranteed to make us loads of money. It’s almost a sure thing!

It’s not a sure thing, though. If you were foolish enough to put all of your money in the trade each time out thinking that you need to risk the most to make the most, you would basically guarantee that you go bust.

Why?

Because a 90% win rate is not 100%. You will eventually have a loser, and once you do you are done. You may have made tens of thousands on your trades to that point, but one loser would erase all of that. In fact, if you do enough trades you are almost assured of having a streak of 3-4 losers in a row. So even if you said, “well I’ll just cut my per trade risk in half to 50%” you are still probably going to end up wiping out your portfolio at some point.

The point here is that every trade you make comes with a risk that you lose money. No system or method is perfect. You will hit losers, and probably losing streaks. That is the risk of trading. Money management is the process you use to minimize the damage those losing trades and/or streaks have on your portfolio while also maximizing the gains you make over time.

This part of trading is what differentiates those who are long-term performers and those who are flashes in the pan. Anyone can pick a good trade or two, come up with a decent trading system, and all that. It’s the ones who master risk and money management who enjoy longevity in the markets.

Bookmark to: