by Rick Ratchford
It is a rare bird that can enter into the business of trading and do it well from the start. Like most things worthwhile, trading requires time to learn. One must learn the basics of finding a broker, proper order placement, how to read price charts, and whether to become proficient in technical analysis and/or fundamental analysis.
At this point, the new trader needs to hone his skill in the analysis of choice, understanding clearly how to use various indicators or how to interpret external influences, that which is usually provided by way of weather and crop reports, or other kinds of government releases.
Of course, the best teacher of all is in the "doing." To place a trade and work it from start to finish. Win or lose, the experience should help the trader become better, if the trader is "tuned into" the process and experience. Sadly, many don’t learn from previous lessons only to repeat it again and again. Every trader, from the novice to the professional, is going to lose trades. That is a given. But the trader that is able to continue trading again and again after a loss is the one that has likely learned early on the wisdom of risk and money management.
Simply put, a trader who acknowledges that he/she is going to lose a trade is going to know how to limit those losses. When the losses are small, the trader not only has the resources to trade once again, but is not mentally devastated as well. What traders need to understand is that it isn’t the big losses alone that can end the trading career. It is the mental damage those big losses can cause.
One analogy would be that of the gambler. Upon losing all his money on payday, he comes home to his wife and kids who depend on him for support. Unable to provide this, mental damage occurs due to stress and the feeling of failure. But then another animal surfaces, no longer the calm and collective person prior to losing, but one that is not reasoning properly. The overwhelming emotion here is the strong desire to "get even," to win back what was lost. Had the amount been small, the gambler could have simply shaken it off as "entertainment" costs. However, because it was more than simply that, the "double-or-nothing" mentality kicks in, and this person is doomed to repeat his errors.
The trader should always keep his losses small. They are so much easier to take. The mental damage if any is very minimal, and it allows the reasonable trader to reconsider his/her approach and try again and again. Unless the method is seriously flawed, a trader should be able to win trades. If you give yourself a chance to succeed by limiting your losses, you will have more chances to learn how to make your wins bigger.
Risk management is the component of limiting losses. You decide if the method of choice will provide you with the means of limiting your losses, in keeping them small. This is important for your success.
Money-Management is the component of trading within your means. You simply must calculate by some reasonable formula how many contracts to trade at any given time in relation to account size. If you are trading with a small account, you simply limit the number of contracts to one. As your account grows, you will come to a point where two contracts are within reason.
Both Risk and Money management require discipline to successfully execute. If the trader starts to over trade due to gut feeling, or lets a loss get bigger for likely the same reason, than discipline has been replaced with a gambler’s mentality, and damage may occur. It is important for the new trader to understand the danger of not following a reasonable plan of risk and money management.
Discover an acceptable risk and exposure that fits your situation, and have the discipline to stick by it. Keep in mind that any deviation from your plan will likely not only sour a trade, but possibly many trades to come due to the psychological aspects involved. Unfortunately, many new traders don’t think that psychology plays a part in successful trading. Because of this, they start off throwing caution to the wind and soon find that they "mentally" can’t take the heat anymore.Plan to keep all your trades at a low risk level by setting some kind of limit on losses. Also, set limits on how much you will trade for an account size time frame. If you keep your per trade losses acceptably low, and do not over-trade, you will give yourself a chance to succeed.