7: Manage risk and protect capital
Properly managing risk and protecting trading capital is what keeps traders in the game. They also should avoid risking too much on any single trade. The generally accepted industry standard is to risk no more than 2% on any single trade. Many traders with smaller accounts find this limits their ability to make substantial profits and may, as a result, risk far more. All it would take is a series of losing trades to destroy the account.
Trading with a stop loss is another way to manage risk and protect capital. A stop loss limits the risk that a trader is exposed to for each trade. We all would like to always exit with a profit, but that is not realistic. Because losing trades are inevitable, it makes sense to know how big those trades are going to be. If the trade moves in the wrong direction, it is closed and the trader moves on to the next opportunity.
Being undercapitalized — not having enough money — is perhaps the primary reason why many traders fail. This is for a couple of reasons. One is that traders need money to make money. Imagine a trader makes a 30% gain in one year. That might be enough to live off if it’s based on a $200,000 account. However, 30% of a $5,000 account is not enough to pay the bills. Being undercapitalized also is detrimental because it becomes impossible to withstand the inevitable drawdowns. Again, it wouldn’t take many losing trades in a row to wipe out a small account.
8: Know when to stop trading
There are two primary reasons to stop trading.
The first is that the trading plan is ineffective and losing more than anticipated in historical testing. Markets change, interest and volume in particular trading instruments vary and trading plans simply may not perform up to expectations. It may be time to take a step back and reevaluate the trading plan, remaining businesslike and unemotional throughout the process. An ineffective trading plan is a problem that needs to be solved; it does not necessarily mean the end of the business.
The second reason to stop trading is that the trader is ineffective. Factors such as emotions, external stress factors and bad health can have a negative impact on trading performance. A trader could develop a winning trading plan, but it still could fail if he is unable to execute the plan properly. It is beneficial to both the trader and the business to recognize any personal challenges and take measures to improve the situation. If a trader has trouble with emotions, for example, he may benefit from using some type of strategy automation.