Stocks go up and down. We hit resistances and supports. The market rallies and it corrects. As traders, we look for the best opportunities in the market and try to make the most profit from them.
We spend hours looking for the best trading system: We learn 100 new indicators only to fill our screens with meaningless lines and strokes. We scan for the strongest stocks with the best setups- only to lose bad and wonder why our cut loss point could possibly be hit.
Each loss hits us harder than the one before as we see our portfolio gradually hammered down as a nail to the ground.
The key to break past this roller coaster ride of agony in losses and self doubt?
Risk Management.
The Coin Toss Game
Ever heard of the coin toss game? It's an interesting illustration that shows the mindset we are to approach the markets with.
The game requires us to flip a coin 100 times. For each flip we could either win (heads) or lose (tails). We start out with 100 points, and for each loss, we subtract one. But for every win, we add 2. That's it!
So what has this game got to do with trading? Here it is:
The 100 points is our starting capital. Each coin toss is a single trade. We risk 1% each trade for a reward of 2%. It's a 2:1 win-loss ratio. There will be losses and wins, but the principle is to keep your wins bigger than your losses. For every winning toss/trade, we gain back two losses.
Probability and Discipline
Doing the math, we see that we only have to win 33% of the time in order to break even. That means we could lose close to 70% of our trades and still have our capital intact! In fact, I even ended up with 155 points or a 55% gain on my first try!
And if you skew the odds even more, the higher the reward for each percentage of risk, the less trades you need to win in order to gain back your loss. A win-loss ratio of 3:1 would only need you to win 25% of your trades in order to break even!
Trading is not about that one perfect stock or trade setup. But it's about the proper mindset and execution.
The one principle you need to know by heart in trading? Risk management. Keep your losses small, and your wins big. Use the risk percentage technique for your allocation for each trade. Stay disciplined and watch the probability play out in your favor!