Simple money management wins over time

December 31, 2011 06:00 PM

Indeed, the order of the winners and losers has a major impact on how your account grows. In "Splitting our losses" (below), we depict the same 40% win rate, but the sequence varies with two large blocks of losers separated by a string of six winners. The ultimate final profit is the same. However, in this case we got there after suffering just a $3,000 drawdown.

Why losers lose

The issue here should be obvious. You can’t predict the order of trades and must be prepared for the worst. Say you start with $8,000 and that you need at least $2,000 (the initial margin requirement) to make each trade. If you have eight losers in a row, you are broke. In fact, six losers in a row and you are shut down, taking into account fees. You can’t last through the full 20 trades. Rather than making $4,000, you are shut down with massive losses when your account dips below $2,000.

The worst case scenario is that you could lose 12 straight trades and then hit eight straight winners. In other words, to make the $4,000, you would need more than $14,000 (the losses plus the initial margin) to even begin trading. The likelihood of such a string of losses is remote, but it could happen.

That is the reason that most traders end up losers. They don’t allow for the possibility of a major string of losing trades. The truth is that while the worst-case scenario may be unlikely, something approaching it has a relatively high probability of occurrence. Over time, it is a virtual certainty that at some point all traders will suffer a long series of losing trades.

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About the Author

Joseph Stuber began his career in 1972 as a research analyst. He is an author and lifelong student of risk and risk management.