There is a classic, amusing but nevertheless wise, piece of advice about managing money: Rule #1 is don’t lose it. Rule #2 is don’t forget Rule #1. When trading financial markets of any kind never losing money is not literally possible. Nor is the foregoing advice meant to be taken as an absolute. Having losing trades is going to happen, indeed regularly if you trade frequently. Thus your only choice is to be prepared for losses and to strategize beforehand accordingly.
Which leads to a second piece of time-tested advice which every beginning trader would do well to memorize and every veteran trader who has survived knows: Cut your losses and let your profits run. The simple mathematics are that if you limit your losses then you only need a similar small gain to get back to break even. If you incur a 20% loss you need a 25% gain to return to break even. A 25% gain is an excellent monthly return for a good trading system, but not a totally improbable return. Allow a 50% loss to happen? Then you need to double your money to get back to your starting point.
If you have a trading system that gives you a mathematical edge over time, you should nevertheless be prepared for significant drawdowns at times over an extended period of time or series of trades. Markets are inherently random and capricious, so one had best be prepared for the equivalent of a fair coin flip landing on “heads” 10 times in a row (a 1-in-1,024 chance). A real world example involves the frequently cited statistic that markets fluctuate 85% of the time and trend only 15%. Thus a trend-following system can be expected to suffer drawdowns at times, say by prematurely trading for range breakouts along the path to eventually catching a major wave which earns those losses back and then some. (Any trend following trading system that endures must prepare for this happening regularly.)
Enduring a series of small, and therefore manageable, losses is one thing. That ongoingly gives one time to reassess one’s system and – most importantly – appropriately manage one’s capital put at risk. But taking a major loss on a single trade (or basket of trades built around a single basic call or theme) is simply unwise. If you find yourself down some nontrivial percentage on such a trade or basket of trades, waiting and hoping to “make it back,” then we suggest repeatedly reading this quote from legendary trader Jesse Lauriston Livermore to yourself:
“Trader has to reverse what you might call his natural impulses. Instead of hoping he must fear; instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.”
Then there is this philosophical but very true perspective: Once a loss has occurred your money is gone. It is not the case that “It is only a loss once you realize it by closing the trade.” While you may never go broke taking a profit you will also never get wealthy. And you can very much go broke by refusing to close out a losing trade. Too many times to count we have observed traders blowing out their accounts by stubbornly holding on to a trade waiting for a trade to “come back.” In effect, adopting the mentality of a gambler. Forex brokers who, unlike Spartan, routinely take the opposite side of client trades count on such behavior (and are generally justified in doing so). Your capital is gone, get over it. Cut your losses, let your profits run.
A final consideration is for when you find yourself in a losing trade, either on the verge of or otherwise threatening to breach your stop-loss level which you set beforehand. Are there exceptions to following the rule of NOT “giving the trade a chance to recover”? As a general discipline, no. Per the Jesse Livermore quote above, now you are relying on hope to bail you out of an incorrect trading call. That is an emotional call, and one’s emotions are reliably the enemy of trading success. But if you insist on second-guessing your discipline, ask yourself this: If I had not entered the trade, and thus had no emotional investment in the price’s direction, would I now enter the current trade in place? We find that more often than not the answer is no. The premise regarding the trade was wrong; it is truly time to cut bait.
There is a basic paradox entailed in trading, especially when trading using large amounts of leverage. You should be fearful. Your long-term financial survival requires that. But not so fearful that you never trade at all. Otherwise your capital will stay stuck where it is. (If you cannot afford to lose any capital at all, then you should not be trading the forex market.) The title of this page is risk management, not risk avoidance. The key is to be prepared, as the Spartan warriors in ancient Greece were, when going into trading battle. Be a money manager, not a gambler.
