Trading tutorials for beginners - PART 1: money management & probability
DISCLAIMER: this isn't a trading course. This is a series of articles, with essential information that's required to become a successful (technical) trader, in no particular order.
Money management
Probably the most important factor in being a successful trader is money management. This is probably the main reason most traders fail. A shocking statistic that Forex brokers released is that approximately 97% of traders lose money in the long run! If you don't use proper money management, even profitable trading strategies are guaranteed to lose ALL your money in the long run! There is 1 basic rule in investing money: invest only what you can afford to lose. If you plan on trading the money yourself, these are the steps you have to take:
- Determine your trading capital (how much money you can afford to lose on trading).
- Determine your preferred risk of ruin (what's the chance of going broke after a certain amount of trades).
1. Determining your trading capital
This is personal for everyone. In general, the more absolute money you have, the lower relative risk you want to have. So if you have $1000 you might not care if you lose it all. If you are a millionaire, you are probably going to care if you lose anything over 5%.
2. Preferred risk of ruin
Probability
A trading strategy is subject to nonlinear probability. This means it's an estimation and never possible to calculate exactly. Therefore the only way to calculate your expected value is if you know the statistics of your trading strategy with great accuracy (over a large enough sample size, preferably at least 1000's of trades). If you do not have statistics of your trading system, you are extremely likely a losing trader and it's recommended to practice without real money first. When you have those statistics and they are mathematically profitable, then you can profitably trade for real money.
Risk of ruin
Risk of ruin is a mathematical concept to calculate the chance of going broke after a certain number of periods (trades in this case). You can calculate your preferred risk of ruin with your winning percentage, risk-reward ratio and market exposure. Here's an example of a risk of ruin calculator.
Kelly Criterion
Using the Kelly Criterion you can calculate the exact market exposure you need to optimally profit from your trading strategy without the chance of going broke.
Closing remarks
I hope you are one stop closer of understanding what it takes to become a profitable trader. Now you have the basic understanding of what is required to calculate if your trading strategy is a winning strategy and what your preferred market exposure is. In the next few tutorials we are going to discuss some more basic concepts like stop-loss and leverage and some essential concepts of technical analysis in trading.
Good to know.
Hello @calumus056, I was hoping for a little more information for this post. I would like to share my post which starts with banking & effective money management for investing "the barefoot investor". As I believe its quite an important one steps into trading. I've already been paid for this post so feel free to use any information.
I like to use a 2% rule (2% of capital per trade) for trading forex. Capital drawdown is the biggest reason why people get out of trading, people risk too much in a particular trade. I would like to also share a 19 part tutorial video from youtube about getting started in forex trading this guide includes risk management, anaylsis & psychology.
This is just part 1 of many. It's a really bad idea to go looking at charts right away without understanding what to expect. Many more tutorials to come!
I know everyone uses 2% rules and such. That's exactly why i wrote this article. In this article i explain how you can calculate the exact risk you prefer. 2% for an aggressive strategy is probably too much and too little for a conservative strategy.
Capital drawdown is part of the risk of ruin formula by the way.