Most people who are new to the trading game spot an opportunity and ask themselves, "How much money can I make on this trade?"
Let's see where this question leads.
All too often, it leads to the novice trader diving in with a chunky trade, and hoping (mostly praying) it's going to help make their fortune.
Of course, there's always beginner's luck, but in most cases, you're asking yourself the wrong question.
Too many traders - experienced ones, as well as newcomers - are determined to make a killing on one sweet trade. They spend hours checking out the indicators, the setup and the entry point, all the while convincing themselves a huge profit awaits. Then they steam in.
Let's say our trader always bets £10 a point (equivalent to 1000 shares). Some trades will yield a profit. But others are bound to run up huge losses. All it takes is a couple of duds, and your account is empty.
The fact is, betting the same amount on every trade is one of the main reasons so many traders wipe out so fast.
So what's the solution? In just three words: correct trade sizing. Or to put it another way, adjusting the amount we bet per point on a trade by trade basis.
Back, for a moment, to our Ten Quid Trader,. Let's say he's got £10,000 in his account. One day he places two trades:
Trade No. 1: A short on Barclays, at £10 point. The distance between the entry price and the stop loss, is 10 points. So the most he can lose is £100.
Trade No. 2: A buy on Lonmin. For the usual £10 a point. This time, distance between the entry price and the stop loss is 45 points. Which means the most he can lose is £450.
Trade 1 is successful. But trade 2 hits the stop loss. And the £450 is equivalent to 4.5% of the account... 20 more trades like this and Ten Pound Trader is going to go bust.
Every trade must assume the same risk to the account - without exception. So our Ten Quid Trader needs to undergo a mind reset. Instead of asking, "How much money can I make on this trade?", the correct question is, "How much can I afford to lose on this trade?"
And the best answer is that you can never afford to lose more than one per cent of your account on any one trade. Adopt this risk- orientated trading methodology and you'll eliminate the possibility of being cleaned out by a run of 'bad luck'.
What's more, you'll be ready to take full advantage of that big winner, when it does come along. It's a fact that we can use strategies to increase the probability of a trade working out in our favour. But unless our trading foundation is built on risk mitigation, and conserving our capital, we won't be around for long enough to mop up the rewards.
So back to that £450 our Ten Quid Trader lost on Lonmin. With £10,000 in the account, and a one per cent risk profile, he can afford to lose £100 per trade. The stop loss, remember was 45 points. Which means that instead of trading £10 a point, the optimum per-point amount is £2.20; Same trade. Same movement on the price. But now the damage to the account is mitigated to £99, instead of £450.
Successful trading is about the net amount we make each month rather than individual trade performance. But very few new traders have a monthly trade plan. The simply don't realise how important it is.
So if you always bet the same stake on every trade you place -no matter whether it's £10, £100 or £1, please stop it, and stop it right now. It's a disaster. And unless you mend your ways, you're doomed to join the long list of broken dreamers who come to the conclusion that spread betting or leveraged trading is some sort fix, and provide cannon fodder for the few of us who are doing the right way.
Remember this golden rule: For every trade you place, your trade size should vary and your risk should remain constant.
With risk nailed down, the next area that deserves our attention is strategy. When coaching new traders it is always interesting to note the reasons for placing their trades. Most traders, generally, start off trading from a place of greed. Whether you are a fully qualified financial professional or not, it doesn't matter - the fact is most people fail to differentiate an 'exciting' trade from a 'good' trade.
What does this mean?
Most newcomers will be excited into a trade because that stock is already demonstrating it's a 'mover' and will rush to buy it. Seduced by the lure of quick profits, the newcomer watches in bewilderment as the trade almost immediately turns around and reverses on him. This exposes another of our simple, but crucial rules - which is:
Never enter a trade that has already started a move.
As traders, we look for trade setups that to the novice would look relatively boring and non moving, and we look to enter these trades at periods of low volatility - before the move is underway.
