"Only risk what you can afford to lose" - please help me understand this

grass_hopper · Mar 5, 2012

Hi Y'all,

Every trading book, forum, website, etc. has these words engraved in them: "Only risk what you can afford to lose".
Yet the same sources say that many traders who fail do so because of the lack of capital. Some recommend starting with at least $50K to have a good chance to succeed.

So, what is the right account size to start trading and how to set "afford to lose" limit correctly?

For example, If all one can afford to lose is $5000, does it mean he is doomed to fail? With an account of this size many money management rules (e.g. 2% risk per trade) would be impossible to apply due to commissions and slippage. Moreover, any profits would be miniscule in the absolute terms (20%/year of 5000 is only 1000 and 20%/year is very hard to achieve consistently, let alone any higher number)

On the other hand, if one has $50K he can afford to lose, then what's the point of trading as his income is probably 20 times bigger than that and trading won't add much to it.

How does one resolve this conflict? Where does that extra $45K come from?

Thanks,
GH

donaldduke · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

grass_hopper said:
Hi Y'all,

Every trading book, forum, website, etc. has these words engraved in them: "Only risk what you can afford to lose".
Yet the same sources say that many traders who fail do so because of the lack of capital. Some recommend starting with at least $50K to have a good chance to succeed.

So, what is the right account size to start trading and how to set "afford to lose" limit correctly?

For example, If all one can afford to lose is $5000, does it mean he is doomed to fail? With an account of this size many money management rules (e.g. 2% risk per trade) would be impossible to apply due to commissions and slippage. Moreover, any profits would be miniscule in the absolute terms (20%/year of 5000 is only 1000 and 20%/year is very hard to achieve consistently, let alone any higher number)

On the other hand, if one has $50K he can afford to lose, then what's the point of trading as his income is probably 20 times bigger than that and trading won't add much to it.

How does one resolve this conflict? Where does that extra $45K come from?

Thanks,
GH

Typically you need 50K and you might be prepared to risk 10K of that using good money management techniques.

You still need to put up margin when you are down by almost 10K. Hence the requirement to have a large account like 50K to start with.

Now spread betting firms and other bucket shops allow much higher leverage. So if you can position trade with a spread bet firm you only need to put up 20K or 15K, and if you have a 10K drawdown you probably still have enough margin to carry on if you are using sensible position sizing.

You effectively have to use notional money management when you use a leveraged account and dont put up all the funds.

Say you put 20K in your account, you would treat this as a notional 50K for position sizing purposes (0.5% risk = £250)
If your account drops down to 10K, you treat it like 40K for position sizing purposes (0.5% risk = £200).

grass_hopper · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

donaldduke said:
Typically you need 50K and you might be prepared to risk 10K of that using good money management techniques.

You still need to put up margin when you are down by 10K. Hence the requirement to have a large account like 50K to start with.

Now spread betting firms and other bucket shops allow much higher leverage. So if you can position trade with a spread bet firm you only need to put up 20K or 15K, and if you have a 10K drawdown you probably still have enough margin to carry on if you are using sensible position sizing.

You effectively have to use notional money management when you use a leveraged account and dont put up all the funds.

Say you put 20K in your account, you would treat this as a notional 50K for position sizing purposes (0.5% risk = £250)
If you account drops down to 10K, you treat it like 40K for position sizing purposes (0.5% risk = £200).

I am in the US and spread betting is illegal here. Also, I don't like leverage - it does more damage than good and you may lose more than your account size.
As for 2% rule - I interpret it as the maximum position size for a defined risk strategy (long option, option spread, etc.) or the maximum allowed loss on a stock in case that stock drops more than 20%. E.g. $500 worth of stock or $100 worth of option contracts in a $5K account.

VielGeld · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

You don't like leverage, but use options? Lol. Those things are 100:1 leverage vehicles.

Leverage is a tool, not something to be explicitly avoided. It can do good if used right. But, yes, it does amplify losses if used wrong.

Anyway, only risking what you can afford is only part of the equation. You can set a loss limit at 1% of account per trade and cut the trade once 1% loss is hit. This is your max risk per trade. You could also have a set % at which you stop trading altogether if hit.

Another way of seeing it is only using extra cash to trade with. Meaning it's money you could lose and just forget about without any worries. Don't make the mistake of thinking you'll lose it all from the outset, though. That's not good.

All it comes down to is proper money and risk management. That's what it's really about.

Lord Flasheart · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

Just to add some comments.Most forms of trading cover leverage,even if you trade shares there is often leverage involved,why wouldn't there be. US or UK to trade you need leverage. As for the original question,saying you must only risk what you can afford etc,this is a statement that can never be taken on its own. In my first year of trading I started with £5000 and promtly lost that,made about £3000 in the 2nd,lost about £5000 in the 3rd,that puts me at £7000 down over the 1st 3 years? er no,actually about £67,000 if you assume I can get by on £20,000 a year. Even if I had made 100% a year on my £5000, id still be £45,000 adrift after 3 years. Hopefully you see where Im coming from. Another point, if I say I have £50,000 I can afford to lose,am I seriously going to start with that figure in my trading account,no of course not. I should do as there are many dangers if you do not stake your trades and look at your returns in the right way.What if i have equity of £1m but no cash,do I borrow £100,000 as I can afford to lose it. hopefully you see what Im saying,the statement alone is worthless on its own and each individual needs to think seriously about how they structure their trading and account. Most traders start by looking for the holy grail by way of a chart set up,they spend years looking for it,but really they could have better spent that time making sure everything was in place 1st so as to take the stress away.Ive probably gone of thread on this so ill shut up now

grass_hopper · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

VielGeld said:
You don't like leverage, but use options? Lol. Those things are 100:1 leverage vehicles.

Leverage is a tool, not something to be explicitly avoided. It can do good if used right. But, yes, it does amplify losses if used wrong.

Anyway, only risking what you can afford is only part of the equation. You can set a loss limit at 1% of account per trade and cut the trade once 1% loss is hit. This is your max risk per trade. You could also have a set % at which you stop trading altogether if hit.

Another way of seeing it is only using extra cash to trade with. Meaning it's money you could lose and just forget about without any worries. Don't make the mistake of thinking you'll lose it all from the outset, though. That's not good.

All it comes down to is proper money and risk management. That's what it's really about.

Options can be used to reduce leverage and risk. It all depends on how you use them. E.g. instead of buying 100 shares of stock for $50/share ($5000 total), buy a vertical call spread (50/55) for $2/share ($200 total). Your risk is $200 vs $5000. Or sell ITM covered call / OTM cashed secured put.

As for the money I can lose and forget - rationally, I can lose, say $200/month, but emotionally - I will feel devastated if lose that much on my very first trade. If only I could get rid of emotions and fears :-(

grass_hopper · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

Lord Flasheart said:
Just to add some comments.Most forms of trading cover leverage,even if you trade shares there is often leverage involved,why wouldn't there be. US or UK to trade you need leverage. As for the original question,saying you must only risk what you can afford etc,this is a statement that can never be taken on its own. In my first year of trading I started with £5000 and promtly lost that,made about £3000 in the 2nd,lost about £5000 in the 3rd,that puts me at £7000 down over the 1st 3 years? er no,actually about £67,000 if you assume I can get by on £20,000 a year. Even if I had made 100% a year on my £5000, id still be £45,000 adrift after 3 years. Hopefully you see where Im coming from. Another point, if I say I have £50,000 I can afford to lose,am I seriously going to start with that figure in my trading account,no of course not. I should do as there are many dangers if you do not stake your trades and look at your returns in the right way.What if i have equity of £1m but no cash,do I borrow £100,000 as I can afford to lose it. hopefully you see what Im saying,the statement alone is worthless on its own and each individual needs to think seriously about how they structure their trading and account. Most traders start by looking for the holy grail by way of a chart set up,they spend years looking for it,but really they could have better spent that time making sure everything was in place 1st so as to take the stress away.Ive probably gone of thread on this so ill shut up now

Inspiring, but I got lost in your math. How did you arrive to £67K loss?
Your tally: -5000+3000-5000 = -7000. Where did extra 60K come from?

Regardless, I have this irrational fear of big, devastating, loss and I don't know how to get rid of this fear.

Lord Flasheart · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

grass_hopper said:
Inspiring, but I got lost in your math. How did you arrive to £67K loss?
Your tally: -5000+3000-5000 = -7000. Where did extra 60K come from?

Regardless, I have this irrational fear of big, devastating, loss and I don't know how to get rid of this fear.

the rest was whati spent surviving the 3 years,food,rent etc,etc

grass_hopper · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

Lord Flasheart said:
the rest was whati spent surviving the 3 years,food,rent etc,etc

Then you're mixing your trading losses with your other expenditures. I don't mind spending 5K on food, clothing, etc. (I get something in return for my money) but I would hate to simple lose it in the market getting nothing in return.

Splitlink · Mar 5, 2012

Re: "Only risk what you can afford to lose" - please help me understand this

grass_hopper said:
Inspiring, but I got lost in your math. How did you arrive to £67K loss?
Your tally: -5000+3000-5000 = -7000. Where did extra 60K come from?

Regardless, I have this irrational fear of big, devastating, loss and I don't know how to get rid of this fear.

Don't get rid of it---it's your protection. As the Spanish say "Walk with lead shoes"
The trading ring is a jungle that wants your money.

Caveat emptor.

"Only risk what you can afford to lose" - please help me understand this

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