One of the most important things I talk about in these articles is capital preservation.
In fact, I don't think there is a more important subject for traders.
Why do I say that?
Quite simply, because if you don't preserve and ultimately grow your capital, then your trading account will evaporate before your eyes, just like a puddle on a summer's day.
Losses are part of the trading landscape, traders have to get used to having losing trades.
They shouldn't fear losses; they should accept and expect them, as a cost of doing business, which is what they are.
However, there should be a small part of the trader’s make-up that resents losses, and a bigger part of that make-up that does its best to keep them to a minimum, and (if possible) a quantifiable minimum at that.
Of course, we can’t know the outcome of every trade before we take it.
However, we should go into each trade with the knowledge that the likely outcome is slanted in our favour.
That is, the trade has a positive risk-reward ratio, such that our potential profit is always a multiple of the capital we are risking when we open the trade.
No positive risk-reward ratio, no trade should be our mantra
As we can see from this graphic, we need to have a win-loss ratio of at least 30.00% on a risk-reward ratio of 3:1. Or greater, or a win-loss ratio of 50.00% at a risk-reward of 2:1 to be profitable.
The higher the win rate and the risk-reward ratios in your trading, the better the outcome is likley to be.
Source: TradingView
The asymmetry in P&L outcomes
Profit and loss may be flip sides of the same coin, but they are not uniform when it comes to the effect they have on your account.
That’s because a -10.0% loss and a +10.00 % profit act in very different ways on your account.
If your account falls in value by -10.00%, it would be tempting to imagine that a +10.00% gain will bring you back to flat.
However, that isnt what happens as we can see in this example below:
Account value $1000.00
-10.00% loss
New Account value $900.00
+10.00% gain
New Account Value $990.00
Shortfall = $10.00 or 1.00% of the Original Account Value, or 10.00% of the Original Loss
What’s more, the bigger the initial loss, the harder it is (the more work that’s required) to fill the gap.
Account value $1000.00
-25.00% loss
New Account value $750.00
+25.00% gain
New Account Value $937.50
Shortfall = $62.50 or 6.25% of the Original Account Value, or 25.00% of the Original Loss.
And so it goes on .....
Loss Aversion
Even when we know this asymmetry in outcomes exists, we can still fall foul of it and its effects on our trading capital. Thanks to an inherent and subconscious bias thats present in all of us, which is known as loss aversion.
Which can be defined as:
“Loss aversion is a cognitive bias under which the pain of a loss is felt more strongly than the pleasure of an equivalent gain. Its existence suggests that people are more motivated to avoid losses than to acquire gains. This bias can lead to decisions that prioritise preventing losses over maximising potential gains.”
This manifests itself in trading when people run losses beyond their predetermined stop loss or monetary/price action limits.
In extreme cases, traders will close out other profitable positions to support/maintain a losing trade in the hopes that the loss will turn around and move back to profitability.
Something which, in my experience, rarely happens .
Loss aversion is an example of what happens when we become emotionally attached to a trade.
At some level, the trader can’t admit to themselves that they are wrong, and so they pursue an irrational course of action rather than acknowledge reality.
Capital preservation ensures that you are exposed to the largest amount of trading opportunity for the longest period of time, which in turn should mean that your trading capital will grow over time.
However, neither of those things will happen if you don’t adopt a disciplined and consistent, rules-based or systematic approach to your trading and risk/money management.
Without which, you are just gambling when you trade.
In the same way that you are, when you toss a coin, only in this instance, the coin is loaded against you.
Compounding your returns and minimising your losses, both in terms of their frequency and their size is the route map to trading longevity and trading success, but that doesn't happen overnight.
However, it happens a lot quicker once you to start to heed this kind of market wisdom..
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