Trading is all about risk and money management. Many traders don't give much importance to risk and money management. They learn it after getting their fingers burnt in a string of losing trades. You see, you have a finite amount of money. It can be $1,000 and it can be even $1,000,000. But it is still finite. Once it is gone. It is gone. As simple as that! The riskier you're trading strategy, the more thought you need to give to your money management style. Otherwise, you can find yourself out of the market with a margin call in no time. Let's say, you trade 100% of your account. You only need one losing trade to lose 100% of your account. Suppose, you divide your trading account into 10 equal parts. Now, you can have 10 losers before you are out of the market. You want to reduce risk further in your trading. You divide the capital in the trading account into 100 equal parts. Now, you only risk 1/100 of the capital in the trading account on a single trade. Suppose you lose. You only lose 1/100 of the capital. Suppose, you lose 100 times in a row. You are done. But the chances of making 100 losing trades in a row statistically speaking are very very low. So, you are on a more safe ground. This is the essence of risk management. You only risk what you can afford to lose. Experienced traders divide the capital in their account into 50 equal parts and they risk only 1/50 of the capital on a single trade. In other words, they don't risk more than 2% on each trade. This should give you the idea. Trading is all about long term survival. You lose in the start but eventually you start hitting winners consistently. This grows the capital in your trading account into a large sum by compouding the wins overtime. But there is always a trade off. Remember the most important rule in finance, "no risk, no return." In other words, the more return you want, the more risk you will have to take. But how much you should risk to get a decent reward? This is the most important thing for you. You don't want to risk everything of course. So you don't want to risk everthing on a single trade as long as there is some risk of losing your money. But at the same time you want a decent return to make in your trading otherwise there is no purpose of trading. So, how to go about it. How to decide the risk return trade off? What you need is a mathematical risk and money management system that can tell you how much you should lose on a single trade. Have you heard anything about the Kelly Criterion? Kelly Criterion was developed in 1950s in the Bell Labs for dealing with the noise in telecom signals. Soon, gamblers found it out and started using in their gambling systems. From there it entered into trading systems. In order to calculate the percentage of your trading account to put at risk, you need to know the percentage of your expected winning trades, ratio of winning trades to the losing trades as well as the return from the winning trades. These ratios are unique to each trading system. Once you have them, you can calculate the percentage of your trading account that you can risk with that trading system; Kelly %age=W-{(1-W)/R}. In this Kelly Formula, R is the average gain of the winning trade or what you call the average return per winning trade. W is the percentage of winning trades that that trading system makes. To be on the safe side, many traders divide that number with 2 and only risk that amount per single trade with that trading system.Each trading system has its unique Kelly Ratio. It is essential that you know the Kelly Ratio of a trading system before you use it in your trading!
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