When discussing trading with friends this is the number one question that always comes up: “What’s the rate of return you’ve got?”
I usually had to reply “I have no idea! Because.. i don’t care!“. And then i have to explain (all over again) why it is absolutely wrong metric to focus on.
The shortest (and incomplete) explanation goes like this: when you are racing car/motorcycle should you be focusing on your gas mileage? Should a basketball player focus on his last year statistics. Or should he be focusing on training, skill development, team-play, physical and mental preparation, on the game itself?
I guess it all comes down to the fact that people with no(t enough) experience in trading cannot imagine themselves making decisions that will result in loss of capital. But they can very well imagine making large profits.. and all that stuff they could buy for those profits. So if the rate of return is bigger they can buy even more stuff even more quickly! More, more! Because more is better!
It’s not a loss if i don’t close that trade! I can just buy more and bring my avg. price down! I just have to wait a little longer to make up the losses! Right?
Of course not. Because outside uninformed mind (i.e. the real world) stuff happens! Losses do occur and they don’t go away. This is what you SHOULD be focusing:
- how big is the maximum risk.. i.e. how much i can i lose?
- is the maximum loss only tiny part of my capital so i could continue to trade another day?
- are the expected gains large enough compared to maximum loss- is this risk even worth taking?
- how quickly can the “risk” happen – do i have any options to change my positioning while the “risk” is happening? risk happens very slowly at first… and then all at once.
- what is my plan on mitigating timing errors? no matter what you are told, nobody can time the market perfectly.
- what is my exact exit strategy when i’m up money? and when i lose money?
- am i mentally prepared to execute the trade (take the loss or leave money on table)?
Those are the things i focus on. I built Your.Capital around those concepts so that my emotional and irrational mind couldn’t play tricks on me. Because i am 100.0% sure that i am unable to completely avoid trades that will result in loss. Most important thing is i preserve my capital and be able continue to keep my winners much bigger than my losers.
And that just isn’t possible if you don’t focus on risk management.
Profits are just the by-product of risk managed well!
Here are the final results of that election trade (rate of return on capital highlighted).
So what do you think – how well was that risk managed?