Minimize Trade Loss and Master the Market

After defining your trading float, your maximum trade loss needs to be defined. This is a core principle of excellent money management. The maximum trade loss is quite simply the maximum amount of capital that you're willing to lose on any one trade. The reason for defining this upfront (before we even open a trading position) is to make sure we can stick to one of the cardinal rules of trading and that is to keep our losses small. We want to make sure we set our maximum trade loss as a small percentage of our trading float so it won't have a detrimental effect if we have a string of losses.

Most traders fail in the markets because they risk too much. As I said, the goal is to keep our losses as small as possible while also making sure that we open a large enough position to be able to capitalise on profits as well.

Former Australian test cricket captain Steve Waugh says the best advice he was ever given on the cricket pitch was to simply not get out. What he meant was if you're dismissed, you can no longer score any runs and therefore not win the game. Getting runs, Waugh suggests, should not be your primary objective; you should focus on staying in the game. It's the same in trading. You need to protect your float just as you would protect your wicket in cricket. If you're bowled out, you can no longer play.

I realise it might seem like a somewhat negative or defeatist attitude to spend time thinking about the maximum you can bear to lose but, like I've said before, much of the psychology of a good trader is counter intuitive. It's a question of survival. You want to take a defensive stance when it comes to trading.

Top trader Ed Seykota ius a very strong advocate of minimizing trader loss. He defined the three elements of trading as: (1) cutting your losses; (2) cutting your losses; and (3) cutting your losses. If you follow those rules, he said, you might have a chance.

The first step is to acknowledge that losses are a part of trading - everyone has them. You need to accept it when it happens and move on. Getting upset about a loss only clouds your judgement, which can be trading suicide. A clear head is everything.

So, the question remains: what should be your maximum loss? Maximum trade loss is usually represented as a percentage of your trading float and studies suggest you should never risk more than 2% on any trade - known as the '2% rule'. However, many pros will tell you that this is way too much. They'll risk anywhere from 1% to even as little as a quarter of a per cent on any one trade. The core principal being that no one loss is really going to affect you. That said, typically speaking, your losses may be small, but so will your profits.

Let's look at an example of the 2% rule in action. If we had a trading float of $20,000, applying the 2% rule would mean our maximum loss would be $400 on any one trade. The beauty of having made losses so small by using the 2% rule is that we need a huge string of losses before our entire trading float is eroded.

We would need a string of 50 losses in a row before we had no more capital left to trade with. In most trading systems the chances of getting 50 losses in a row is very, very slim. However, the chances of going broke are even smaller than that because when you implement the 2% rule correctly, that 2% is actually calculated on the current float size, not the initial float size.

Let me explain.

We already established that 2% of $20,000 is $400. However, if we experienced a loss first off, our trading float would now be reduced to $19,600. If we then calculate 2% of this new trading float value, we should then use this figure as our maximum trade loss for our next position. Two per cent of $19,600 would be $392. So, you can see that with every fall in equity our maximum loss falls too.

Here's what would happen if we sustained six losses in a row based on these numbers.

Float: $20,000

After loss 1: $19,600

After loss 2: $19,208

After loss 3: $18,824

After loss 4: $18,447

After loss 5: $18,079

After loss 6: $17,717

Our trading float, after receiving six losses in a row, would have decreased to only $17,717. That means we've only lost $2,283. Minimizing trade loss this well will ensure you have a chance of success. That's what I call managing your risk!

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