Capital management is one of the most important pillars of trading. If we trade to generate profits it is important that we learn to manage our funds, profits and losses. There are many trading strategies in the market but none of them will be useful if we do not have a detailed plan on how to limit our losses or how to maximize profits, how much to risk, what to do after a string of losing trades, how to avoid losing what we have won in the week or in the month and so on many other things related to our money.
Not having a defined capital management takes us away from the figure of a professional trader and brings us closer to the figure of a gambler. A bettor seeks to win money on each bet, a Trader knows that not all operations will be positive but that at the end of the month he will be able to say that he has won money.
Now that we know that Capital Management is very important, let’s see what happens when you don’t apply management.
Let’s assume you have a US$ 100,000 account and lose US$ 50,000. In percentages, we can say that you have lost 50% of your account. Now we are going to see something more interesting, you now have funds for US $ 50,000 (remember that you lost the other half), what percentage of this US $ 50,000 do I need to earn to return to my initial capital, 50%? Well no, you need to earn 100% to get back to your starting capital of $ 100,000.
We have begun to learn more about the concept of Drawdown, in our case it was 50%. The Drawdown allows us to know what the maximum loss generated has been, for this it evaluates the losses generated from the last peak of your capital to the last floor of your capital.
Here you can see an example of the Drawdown.
As you have already seen, it is easy to lose money and difficult to recover it. Having a 50% drawdown can be excessive but it may happen. You may not lose 50% of your money in a single trade but you may lose that 50% in many trades in a row, what we call a losing streak, no system gives 100% winning trades so it is very possible that at some point you will have one of these streaks.
Here we will show you what happens on a losing streak and how you can manage it to stay afloat without much trouble. Remember that you are a Trader and not a gambler, always look at your trading as a long-term system in which in the long run you must make money and stay positive. In the short term you may lose some money but always think about your gains in the long term.
Conservative vs Risky Management
In the previous image we can see what happens to your account when you do a conservative management (risk between 2 – 3% per operation) and what happens when you do a risky management (risk 10% per operation).
We are assuming that you have a string of 20 negative trades, if you risk only 2% for each trade, you still have about US$ 34,000 to continue trading which is much better than just having US$ 6,000 which is what you would have if you had risked 10% per operation.
Even if you had 7 losing trades one after another, see how your capital varies dramatically. If you risked only 2% per trade you would have lost at most US$ 6,000 but if you risked 10% per trade you would have already lost half of your account.
In this new image we can see how important money management is in our trading. The more capital we lose, the more difficult it will be to recover it.
For example, having a 10% loss is manageable since you only need 11% to overcome that loss. Can you imagine what it would be like to lose 50% of your account? You will need to earn 100% of your capital to recover. Losing 80% brings disastrous consequences, you need 400% to recover all that loss.
Risk only a small percentage of your account, this will allow you to have positive results in the long term and will avoid the arduous struggle of having to recover from substantial losses.
Risk / Benefit Ratio
Defining a risk/reward ratio is also a very useful tool in capital management. How could you apply it? Carrying out operations in which profits are sought up to 2 or 3 times greater than what is being risked. This gives a boost to your goal of being profitable in the long term, we will see it here.
This is an example of the gains that can be generated in the long term if you apply a risk/reward ratio of 2:1 or 3:1. You can see that even losing 50% of your trades you can end up with profits in the long run. This is what we mean when we talk about maximizing profits and minimizing losses.