By Gabriel Negrín -
Picture this: after following for months a lot of different traders on Twitter and reading a ton of trading books on Elliott Wave Theory, Fibonacci retracement, price patterns and candlesticks from which you understood only half of what they said, you decide that is time to jump into the market, either forex or crypto. You look at yourself in the mirror and say: “So, do you want to reach your financial freedom or not? This is your chance and you have got to take it”. If this has ever happened to you, congrats, you have taken one of the most important decisions you could have by deciding to start trading.
Yet, trading is much more than what it is said on all the books you have read – yes, all the theoretical reading makes you understand a lot of the psychology behind the market you decided you wanted to enter, but it is not as easy as counting two plus two. As already said, you get to understand the psychology of the market, yet understanding the psychology behind yourself is a lot harder and this is put to the test when you deposit your first collateral on the platform on which you decided to trade.
And now what?
Truth is losing money can scare everyone easily, it is within us and is something as old as our own existence – I am talking about the so-dreaded loss aversion. Israeli-American psychologist and Nobel winner in the field of economic sciences, Daniel Kahneman, suggests that losses have between 1.5 and 2.5 more psychological impact than gains, that is, having a losing trade in which one loses around 5 dollars can have exactly the same impact of a winning trade in which you get a 10 dollar profit. Psychologically speaking, people prefer not to lose 100 dollars rather than winning the same 100 dollars.
One might say, how can one avoid this from happening? Plot twist: you actually cannot. Truth is, you are going to have losses and anyone that assures you he or she has a 100% win rate is probably lying or trying to scam you.
Let’s say you have the mental strength needed to continue – good for you, but like all the books you read and as logic implies, you do not want to put all the eggs in the same basket. Risk management comes in the scene.
The flaw in risk management’s most common strategy
Oh, risk management… that beautiful thing that makes the difference between traders that survive and get to be profitable and the ones that get wrecked after a little while. As it is widely known and accepted and as some sort of general consensus is that you should only risk 3% at most of your total portfolio in each trade and if you cannot open a trade with only 3% of your capital, that would mean that you are decapitalized and risking way much more than you should, thus you should not be considering trading as it is a risky market and you can end up losing something you are not able to afford to lose.
But let’s imagine you get to be a successful trader – let’s say you get a monthly ROI of around 54%, and that’s without playing with leverage. You are doing great. You are using the 3% rule, so you are risking only a little bit of your portfolio. And let’s say you have a bigger plan. You plan on saving some of your profit to buy a new car. After God knows how many months without taking any profit, you have enough money for it – congrats, you have a new car! But now, you see something that was obvious but you failed to notice: the 3% rule allows your portfolio to grow slowly as long as you do not withdraw any profits. If you take profits to buy anything you need, you're back at point 0, right where you started.
This is part of the savings paradox – savings are just postponed spending. When you decide to not spend 20% of your income because you want to buy that new car, we technically say you are saving it, but in fact, you have decided to spend it later.
How to live from trading
Everyone who enters trading wants a single thing – financial freedom. How to achieve financial freedom? This may sound a bit harsh, but you can achieve financial freedom by having a ton of money. And as it has already been stated, we need a strategy for that. By no means, it is implied that the 3% rule for risk management is full of lies and it is not worth the try, yet there could be a better way in which you can make a living out of trading. And I mean that by mixing different strategies and making them our own.
For example, let’s say you decided to deposit $2,000 as collateral to trade. You calculate your 3% to it and see that according to that your first trade would be $60. Too much? You decide to take a more conservative approach and you go down to 2%, which would mean that your first trade would be worth about $40. Now let’s say you decide to mix this with another risk management strategy: dollar risk model.
The dollar risk model basically implies that you will have a fixed dollar quantity per each trade. For example, you decide you will enter every trade you take with only $20. No matter if you lose the trade or if your portfolio continues to grow as you are winning more and more trades, you will always trade $20.
To be honest, this is not a black-or-white situation, there can be much more than just two choices, including plenty of strategies that are in between them as some sort of grey color.
Why not mix the 3% rule and the dollar risk model? You have deposited $2,000 as collateral to your forex or crypto exchange of choice, you calculate a 2% risk, which would be $40 per trade and you establish that you will enter each trade with $40 – in case of losses, all the profits made would serve to round off the initial collateral of $2,000, and all the profits made on top of our collateral will be money that we will have at our disposal to do whatever we want.
Nonetheless, we need to remember that there is no final trick to succeed in trading – each trader needs a strategy that fits his or her context and needs. You, as a trader, need to define your plan and strategy on how to calculate your position and on how often you can withdraw your winnings by yourself. In simpler words, you need to do your own research. DYOR.