Despite apparent crucial importance of the fact that the trader must know when to enter the market, many professional traders consider criteria for capital and risk management of personal trade paramount! Only they are paramount, and nothing else! Markets are constantly changing and different periods and phases come and go. Accordingly, systems and patterns of trade, which worked yesterday, today can fail. That's why rules of capital management are the only reliable island in the storming oceans of markets. And professionals will never back down from them, because it's the only thing that will save you in case of complete lack of understanding of the changes taking place in the markets. Models and methods of management of risk in trading and management of commercial capital perform the most important basic function for a trader - saving capital.
Here, everything can be represented in a unified and universal form - cut your costs and increase profits!
Almost all, without exception, rooky traders are beginning to think about their trade route, only in terms of profit. And the emotional question of how much I earn immediately gives way to the question, how much can I lose. Although the second question is more important. If potential losses of any operations make up half of your capital, then a couple of unsuccessful operations in a row will instantly kick you out of the market and possibly for a long time. Therefore, it is important to understand that for stable and long-term results, avoiding losses is more important than getting big profits on the basis of two main mathematical principles:
- The greater your account or investment portfolio becomes, the more your capital depends on any particular reduction of percentage ratio.
- Much higher percentage of profits will be needed to recover any losses percentagewise.
It sounds simple and uninteresting for a rooky trader dreaming of a new car or a boat. But usually, the time comes and people start thinking about it, when a series of losses is sobering you and makes you think. Indeed, to make up for 50 – per cent loss, 100% of profit is required, and 33% of losses can be saved by 49 - per cent profit. Aggressive operating plan, which assumes effective return, but is not based on the management of your capital or control of risk is always doomed to failure. Do not believe me? Check it out!
Therefore, development and debugging of personal trading system should be approached with caution. Without fear and greed. With understanding of a few basic principles. To reduce the risk the trader, in principle, can choose from the following options:
- Close (or do not open) position (completely eliminating the risk);
- Sell a portion of the position or buy a smaller share at the initial purchase;
- Increase the "stop-order" until risk is reduced to an acceptable level;
- Wait until the market comes close to a reasonable stop and if the grounds for the operation still exist, execute the operation at this point (valid until cancellation order to limit purchase, similar in meaning to "stop order", is able to automatically solve this problem, but it should be carefully controlled so that the signal for purchase remained in force).
Even if each entry to the market is ideally calculated in time, a series of losses can reduce to zero any account. The best option of risk management approach can be a system that includes the following components:
- You need to have a plan in case things do not go the way you planned;
Lack of good risk management plan is the main reason why new traders fail. Then come disappointment, accusation of the market and leaving financial markets. We believe that the plan should be not just in mind, but also in writing. For example, there are specialized tools that allow you maintaining, planning and keeping of statistics of accomplished trades. Ideally, you just have to take each planned transaction as a working hypothesis. And if something goes against your hypothesis, immediately get out of the deal.
- You must follow the principles of diversification on financial instruments.
In 1990, Harry Markowitz won the Nobel Prize in economics for having demonstrated how possession of a portfolio of financial instruments with high standard deviation, but at that with negative correlation (when some instruments rise, others fall), can lead to greater profitability compared to lower total standard deviation. His work has denied the common knowledge that the price of higher profits is always an increased risk, and showed that apparently risky financial instrument can alone paradoxically, reduce the risk of the portfolio. In the same category of financial instruments holding of several positions is less risky than holding a dollar equivalent of one. Traders can reduce the risk by dividing their capital between unrelated markets. The likelihood that the transactions at the same time will fail in all markets is less than the probability of failure in one market.
- You must follow the principle of diversification of trading systems
Markets are constantly in motion and market phases replace one another. Naturally, some systems work better than others in some phases of markets. Diversification of 2-3 systems can reduce the volatility and the "gaps" in your portfolio to a less profitable but more stable growth.
- You have to observe loss limits
For example, you can set for yourself that under no circumstances you can risk more than 2% on any given transaction and more than 10% in respect of the investment portfolio as a whole. This does not mean that you cannot use your entire portfolio for operations. You just set the limit or insure your capabilities in such a way that your maximum loss on any transaction could not exceed 2% of your portfolio. Such a commitment would mean that if in any month, your losses will be more than 10% of the total amount of your capital, you should stop the operations and review your approach more carefully, and give yourself time to put your emotions in order.