Keep your Skin in the Game

Asad Dossani
Most discussions about trading focus on generating ideas. What is the next big trade? What will the gold price be one month from now? Coming up with good trading ideas is necessary to be successful. But it is not sufficient.

An equally important component of trading is risk management. The financial crisis in 2008 occurred largely because of poor risk management by banks. It was not a problem that banks held subprime mortgages. The problem was that they held too many subprime mortgages.

Banks' portfolios of subprime mortgages were so large that the crash would have wiped them out. And so they needed government bailouts to survive.

As a trader, no one is ever going to bail you out. So you really don't want to end up like the banks did. This is where risk management comes in. Even if you have the best trading ideas, you'll fail without adequate risk management. Conversely, good risk management means you'll still be around even if your trades go bad.

Imagine you have a portfolio worth 100. Suppose you have a losing trade. How much do you have to earn on your next trade to break even?

If your losses are equal to 2%, your portfolio is worth 98. Then you need a return of 2.04% on your next trade to get back to 100.

If your losses are equal to 5%, your portfolio is worth 95. Then you need a return of 5.3% to break even.

If your losses are 10%, you need an 11.1% return to break even. If your losses are 25%, you need a 33.3% return to break even.

Now imagine a worst case scenario where you lose 50%. Then you need a 100% subsequent return just to break even!

As you can see, as your losses get larger, it becomes extremely difficult to break even. And if you have a big loss, it is practically impossible to recover.

The lesson here is that you should only risk a small portion of your portfolio on a single trade. I talked about this last time, and now you can see exactly why.

A good general rule is to not risk more than 5% on a single trade. Beyond a 5% loss, it starts becoming increasingly difficult to break even. In fact, it is even better if you can risk less than 5% on a single trade.

These risk management rules are critical. Now you need to work out how much capital you have available for trading. And then make sure you aren't risking more than 5% on a single trade.

Even if you have great trading ideas, some of them will go wrong. And you don't want your losing trades to wipe you out.

I have come across many traders who failed to implement this type of risk management. And it has cost them dearly. After all, it is certain that at some point you'll have a trading loss.

When I started trading, I wasn't aware of this either. I lost my entire first trading account (that was thankfully small to begin with) because I was risking too much money on each trade.

So don't make the same mistake. And keep your skin in the game.

What percentage of your portfolio do you risk on a single trade? Share your views in the Club or share your comments here.

P.S Risk management plus great trade ideas defines what we do here at Alpha Trader.

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2 Responses to "Keep your Skin in the Game"
PaiwaWaisa
21 Nov, 2014
Asadji, At 5% per trade, how many trades do I have running in parallel ? 20 ? pls help understand. PS: Would appreciate a reply here. Last post has a query that is still not answered.Like (1)
dev nair
21 Nov, 2014
great article ...i hope people keep their greed aside to make quick buck and follow it Like 
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