There is a very high chance that every trader would have heard of the basic rule:
"Never risk more than 2 percent of your capital on a single trade".
Straight forward, this means if you have a $100 trading account, you should not risk more than $2 on a single trade. In other words, you should never lose more than $2 in a single trade.
This is a beautiful rule because it will take 50 consecutive losing trades to blow your $100 account, which in itself is a rare possibility. This rule also keeps us long enough in the market to make mistakes, learn, improve, and make new mistakes.
As simple as the rule sounds, most beginners seldom follow it, mostly while doing discretionary trading, because of the strict discipline needed to adhere to this rule.
One of the reasons could be the lack of understanding of why this rule is the fuel to your trading strategies or trading system, without which the engine cannot run.
Here, my effort is to highlight why this rule is an inevitable part of trading and the most important building block of risk management.
Let us consider this. Suppose you have to bet on a coin toss, and you would win when "Heads" show up and lose when "Tails" show up. Understand that you are just betting and not choosing.
This is to avoid other nuisances of trading biases like Gambler’s fallacy* and clustering Illusions* and to make it simple. The probability of winning on an equally weighted (no edge) coin is 50 percent (Heads showing up).
Although you can have heads or tails consecutively over several tosses, when this process is repeated over a fairly large number (more the better), Heads will show up close to 50 percent of the time. This is the “Law of Large Numbers”.
Before we start playing the game, we need to decide on our bet amount per toss. As we understand that for probability to work, there should be large enough numbers of tosses.
With a limited $100 account, your bet per toss has to be small so that you can play many times. The more the number of tosses, the higher the chance you will win or lose very small.
This idea of a very small loss on account at the end will give you the confidence needed to play the game and keep playing the game. On the other hand, if we bet $10 on each toss, a 10 successive losing streak will throw you out of the game with no capital, or the large drawdown, even from 5-6 consecutive losses, will kill your confidence.
A good trading system or a good trader has only a 40-60% win probability, but for even this probability to work, you need large enough trades. To be in the game, there is no other workaround than taking small calculated risks. But risking small is not only needed for survival but also very important for winning.
Let us see how.
The Wins are generally the function of edge. The edge is what makes you money, but for the edge to play out, again, the law of large numbers plays an important role.
The best example of this is Casinos. In any game, a house edge is usually very small (They need to keep it small to be attractive; for example, the house edge for Blackjack is usually 0.5% to 2%).
The very important point to note here is that, for the house edge to work in favor of the casino, there has to be a large number of plays. A very simple form of edge in our coin toss game of 50% probability can be a reward-to-risk ratio of 2.
This means for every head, you win 2$, and for the tail, you lose 1$. This is a very good edge and would mostly be profitable after 100 tosses (For practical perspective, you can try tossing a coin 100 times - heads $2 win and tails $1 loss and see results after 100 tosses).
The important thing is that the bet has to be small so that you have a large number of plays for this edge to work. On a $100 account, betting $10 on every toss, even for a win of $20, can trouble your account with consecutive losses.
Therefore, even for our edge to work, we need a large number of plays, and this can be only done on a limited capital by keeping each bet small. That is why, even for winning edge, we need to play small to keep playing.
Finally, once again for the conclusion, whether you have a “Nice winning probability” or whether you have “An edge in trading”, you need “ the Law of large numbers” for these to work. With the limited capital of a trader, the only way to convert this into a large number of trades is to risk small in each trade (not more than 2%, less the better).
*Gambler’s fallacy - A typical case is when a gambler assumes non-random distribution. For example, after 6 heads, it is likely to assume tails, whereas the 7th toss is also random and has no memory.
*Clustering Illusions - When something occurs in clusters, it is thought to be more likely to occur in the future, even though it is random.
*House Edge is the name given to the percentage a casino will win over the long term in a particular game.
Guest Post - Written by Mr. Suny Patwal, Bangalore