As traders, one of our most important responsibilities is to define both our trading float as well as our trade loss limits in trading money management. Of course, our trade loss is essentially the maximum amount of money we’re willing to loose as a result of any one trade we make. By defining these parameters we not only ensure losses are kept at a bare minimum, but we all protect ourselves against the effects of multiple losses occurring one after the other.
If traders in general were more reluctant to risk too much, there would be far less failures in the game. Yes, one does have to keep enough a large position open for turning a profit but at the same time, one also has to ensure losses are minimal.
Think about it, for a cricket player, protecting your wickets is certainly more important than making runs. Loose your wickets and you’re out of the game. When it comes to trading, we don’t have wickets but we have a trading float instead. Loose that float and you’re also out of the game.
If you’re constantly thinking about your maximum trade loss, don’t let anyone accuse you of being negative. To the contrary, a wise trader views trading as a game of survival and as such, they make sure they remain on the defensive.
A top trader by the name of Ed Seykota was once quoted as saying, with regards to the three elements of trading, that one should: - A) Cut your losses, B) Cut your losses, and C) Cut your losses.
Losses are a part of trading and they’re something all traders experience. Having said this, professional traders have learnt how to deal with losses. They know they need to accept their losses and then carry on. Under no circumstances do they ever allow losses to cloud the judgment because they realize that if they did, the results could be devastating.
What is the ideal maximum trade loss in trading entry? According to many studies, the ideal figure seems to be 2% of your trade float, hence the well known 2% rule in trading. Of course there are also scores of professionals who refuse to risk more than 1% of their float on any one trade. Remember though, while this certainly minimizes the effect of any losses, it also means your profits won’t be very big.
The advantage of applying the 2% rule is, if for example we traded with a $20K float, the maximum loss we could incur from a single trade would be a mere $400. As I’m sure you’ll agree, we would need to experience an unlikely number of losses before our float would be lost completely.
At $400 per trade loss, you would need to have fifty losses one after the other before being broke. On the other hand, the 2% rule is not based on your initial float but rather on your current float amount. In other words, even after more than fifty consecutive losses, you would still not be broke, and I’m sure I don’t need to point it out, just how unlikely such a string of losses really is.
Let’s see how the 2% rule is applied:
As I’ve mentioned, when the 2% rule is applied correctly, using your current float amount, the maximum loss amount will decrease as your float decreases. For example, once again using the $20K float mentioned above, a second loss would equate to a maximum trade loss of $392, this being 2% of the $19,000 you had remaining after your first initial loss. If you experience a string of six losses in this manner, then your float would decrease as follows:
Float amount: $20,000
Float after 1st loss: $19,600
Float after 2nd loss: $19,208
Float after 3rd loss: $18,824
Float after 4th loss: $18,447
Float after 5th loss: $18,079
Float after 6th loss: $17,717
$17,717 still in the float even after we’ve experienced six losses in a row is something we can be proud off because it shows that we’re minimizing trade losses effectively. As I’m sure you’ll agree, this is exactly what risk management is all about.