You want to be the rich statistician…NOT the gambler because in the long run, you want to “always be the winner.” 

So how do you become this rich statistician instead of a loser?

Drawdown and Maximum Drawdown?

So we know that money management will make us money in the long run, but now I’d like to show you the other side of things.  What would happen if you didn’t use money management rules?  Consider this example:

Let’s say you have a $100,000 and you lose $50,000.  What percentage of your account have you lost?  The answer is 50%.  Simple enough.  Now, what percentage of that $50,000 do you have to make in order to get back to your original $100,000?  It’s not 50%--you’d have to make back 100% of your $50,000 to get back to your original $100,000.  This is called drawdown.  For this example, we would’ve had a 50% drawdown.

The point of that little illustration is that it is very easy to lose money and a lot harder to make it back.  I know you’re saying to yourself, “I’m not going to lose 50% of my account in one trade.”  Well I would certainly hope not! 

However, what if you lost 3, 4, or even 10 trades in a row?  That couldn’t possibly happen to you, right? (sarcasm used)  You have a trading system that wins 70% of the time, so there is NO way you could lose 10 trades in a row. (even more sarcasm used) Well while you may have a good system, consider this example:

In trading, we are always looking for an edge.  That is the whole reason why traders develop systems.  A trading system that is 70% profitable sounds like a very good edge to have.  But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10? 

Not necessarily!  How do you know which 70 out of those 100 trades will be winners?  The answer is that you don’t.  You could lose the first 30 trades in a row and win the remaining 70.  That would still give you a 70% profitable system, but you have to ask yourself, “Would you still be in the game if you lost 30 trades in a row?” 

This is why money management is so important.  No matter what system you use, you will eventually have a losing streak.  Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable. 

The reason is that the good poker players practice money management because they know that they will not win every tournament they play.  Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks. 

This is what you must do as a trader.  Only risk a small percentage of your “trading bankroll” so that you can survive your losing streaks.  Remember that if you practice strict money management rules, you will become the casino and in the long run, “you will always win.”

Let me illustrate what happens when you use proper money management and when you don't...

Here is a little illustration that will show you the difference between risking a small percentage of your capital compared to risking a higher percentage.

You can see that there is a big difference between risking 2% of your account compared to risking 10% of your account on a single trade.  If you happened to go through a losing streak and lost only 19 trades in a row, you would’ve went from starting with $20,000 to having only $3,002 left if you risked 10% on each trade.  You would’ve lost over 85% of your account!  If you risked only 2% you would’ve still had $13,903 which is only a 30% loss of your total account. 

Of course, the last thing we want to do is lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%.  If you risked 2% you would still have $18,447.  If you risked 10% you would only have $13,122.  That’s less than what you would’ve had even if you lost all 19 trades and risked only 2% of your account! 

The point of this illustration is that you want to setup your money management rules so that when you do have a drawdown period (losing streak) you will still have enough capital to stay in the game.  Can you imagine if you lost 85% of your account?  You would have to make 566% on what you are left with in order to get back to breakeven.  Trust me, you do NOT want to be in that position.  In fact, here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account.

You can see that the more you lose, the harder it is to make it back to your original account size.  This is all the more reason that you should do everything you can to protect your account.

So by now, I hope you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account.  Remember, you want to be the casino…NOT the gambler!

Risk to Reward

Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking.  If you give yourself a 3:1 reward/risk ratio, you have a significantly greater chance of ending up profitable in the long run.  Take a look at this chart as an example:

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000.  Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.