Saturday, July 10, 2010

Risk Management

For a system to work, the psychology, discipline is very important, the most important. Next after psychology, risk management comes next. A bad risk mangaement can create stress that affects the psychology. A bad risk management can kill a perfectly good system.

In a fair game, let's say you flip a coin 1000 times and you were to bet $10 per flip on heads or tails, with a starting capital of $100, what is the amount you expect to end up with after 1000 flips? What are your chances of winning?

The answer to the above, you may think you will end up with $100 still for a fair game, no win no lose, 50%-50%. However this is not true. You will have over 90% chance that you will end up with $0, claypot.

This is simply because out of a 1000 flips, as long as you lose 10 consecutive times, $100 is gone. And out of a 1000 flips, the chances are pretty high that you might lose 10 or 20 in a roll.

This is where risk management comes in. Betting $10 per flip or 10% per flip is too high. If you apply proper risk management, and use 1% per flip, your chances to claypot is less than 1%. With the law of large numbers, in the long run, you can always expect the result you are looking at, so you have to stay in it for the long run and not go to ruin after the 10th attempt.

So the recomended strategy to use for risk anagement is the fixed fractional method. Bet a % of the total money you have in your account. This is the best method for blance between risk and rewards.

For beginners, start small, say 0.5% per position. Then as you gain experience and confidence, gradually increase to 1% or 2%.

Now with this, you can start trading without fear of ruins.

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