Why use risk controls?

Every trader/investor must guard himself against drawdown’s, which refers to the
percentage drop in his account size after one losing trade or consecutive losing
trades. For example, imagine that after losing a few trades in a row, your
$20,000 account is reduced to $12,000; that would be a drawdown of 8,000/20,000
= 40%. If I were to ask some new traders, “In order to be back up to $20,000,
what percentage return do you need to generate?” Many would answer, “Since I
lost 40%, I have to make back 40%!” This couldn’t be more wrong! Note that after
losing 40%, the trader now starts with a lower base, i.e. to undo the $8,000
loss, the return he needs to generate is 8,000/12,000 = 66.6%! That is why I
share free training videos on my website to help dispel some of the myths of
trading.

The more severe the drawdown, the harder it becomes to undo the damage, as shown
in the numbers below.

Drawdown % % Required to get back to break even

10% 11.1% (This is easy to make up in one good trend)
20% 25% (This is also fairly easy to make up)
30% 42.8%
40% 66.6%
50% 100%
60% 150%
70% 233.3%
80% 400%
90% 900%

That is why all professional money managers only risk 1-2% per trade. It’s
because no matter how good your trading system is at some point it is a
statistical fact you will have 10 losers in a row. Based on risking only 1-2%
per trade this is only a 10-20% drawdown and easily recovered. 99% of the hype
trading and investing courses in existence don’t say or do this. They say risk
5-10% per trade. It is wrong and will cause you serious financial pain if you
follow their advice.

Many of them also use arbitrary stop loss advice. For example, they say, “Place
your stop at $100.10 because that is on the other side of a major support or
resistance, trend line, MA, etc.”

This makes your risk based on the size of the stop. That is also wrong because
the risk can be too large and it’s not the same risk on each trade.

Others reverse this and say risk only 2% total period and let that determine
your stop. This is also wrong and will hurt you because it is important to have
the correct technical stop.

The answer is to do both. Use a percentage and technical stop together. It works
like this. Let’s say the technical stop is $100.10, but based on your entry
price that is a 3% risk. Since your plan calls for a 2% risk you simply lower
the number of shares you are trading. This lets you stay within your 2% risk and
have the correct technical stop. This is exactly what most professional money
mangers do.

Some say that this will lower their profits because of trading fewer shares. So
what! Study the numbers above again. You know the old quote, “More risk equals
more reward.” Well it’s not always true. Sometimes more risk equals more risk!
If you lose your money you have no chance to make a profit. Even losing 50% is
disastrous because you would then need to make 100% to get back to even.

Like Warren Buffet says, there are only two rules in investing. Rule #1: Don’t
lose money. Rule #2: Don’t forget rule #1.

I’d like to add a third rule. Correct money management and position sizing must
be mastered to insure your long term success.

The good news is that it is easy to have correct money management and position
sizing. I just explained how to use a combo of a % stop and a technical stop. If
you want more of an explanation please visit my free video area on my homepage
and click on the “Why have risk controls” video.