How To Ruin Your Trading Account With A Coin Toss
In my webinars and blog posts, I’ve repeatedly discussed the importance of risk management.
That’s because it’s even more important than your trading method.
Even a good trading method can lose you a lot of money with poor risk management. What’s normally a winning strategy can instead be transformed into the kind of frustration we see here with Minesh:
Now of course I can totally understand Minesh’s rant. No one’s ever happy about losing money. His emotions are running high and that’s never fun.
And although I feel like I’ve talked about risk management a lot in earlier writings (and webinars), Minesh’s feedback demonstrates I need to be a little better at communicating why it’s critical and how to apply it to your own trading.
Let’s look at how this particular mishap most likely originated …
Minesh decided to bet the way he did because I was right about the NASDAQ’s descent the first time. I even made seven-figure profits from it . (Those dollar signs are probably why he went ‘all in’ when I expected another drop.)
However, the index failed to crash further. I was wrong. So I took losses (and sometimes broke even, depending on the trade)the second time around.
But here’s the thing …
Overall, I made far more money than I lost.Despite being wrong the second time, I had a large net profit in the end.That’s because the secret to being profitable -- even after losses -- is risk management.
So let me dive into this a bit more:
First of all, no one is right all the time in the markets. No one. Not even the most famous traders in history.
I’m wrong more than 50% of the time. SometimesI get a few right in a row. Sometimes I get a few wrong in a row. But on average I’m right just under half the time.
So how is it possible to be a profitable trader under those circumstances?
It’s because you should never risk more than1% of your capital on a given trade. That’s how to lose small, yet win big.That's the motto. (Don’t put on a trade unless you see it making 2 - 3 times what you’re risking -- sometimes even more, depending on the situation.)
Don’t stake your entire account on one trade.
That’s so important because the outcome of anyone trade is random. But the outcome of multiple trades is NOT random … IF you have a genuine edge in the market.
Let’s illustrate the “random/not random” nature of “one trade versus multiple trades” with a coin toss example.
Pretend you have a coin that gives you heads45% of the time and tails 55% of the time.
When it’s heads you win 3%. When it’s tails you lose 1%.
Over 100 tosses, you should have 45 heads (and+135%) and 55 losses (and -55%).
That nets out to +80% and obviously, that’s a winning system.
This is how a genuine edge ensures you WILL make money over a series of trades if:
1) You apply that edge consistently and
2) You practise proper risk management while you do so
Yet there’s one critical point here …
On any one coin toss, there’s still a 55%chance you’ll lose.
The “Law of Large Numbers” in this example has just shown us it’s a winning system. Yet on each and every toss there’s a 55%chance of losing.
Can you see why betting most (or all) of your account on one trade is a really bad idea?
It means you’re NOT trading a system. Instead you’re relying on a single coin toss to make or break your account.
When you do that, the system and its win/loss percentages don’t get a chance to work for you. Gambling on a coin toss isalmost invariably a recipe for disaster.
Minesh found that out the hard way, unfortunately.
Get it wrong, and even the best trading system in the world won’t work for you.
But get it right … and you’ve suddenly given yourself a bright future as a trader.
So never forget risk management. It really is that important!