The funny thing with what Warren Buffett says about risk is that it really cuts to the point and hits the nail on the head. Think about it "Risk comes from not knowing what you are doing".. it doesn't get more basic than that, but at the same time it really points out the massive gaps in the average traders trading plan, or lack there of. It is not a secret that a huge number of aspiring traders never make it. My belief is that they never really understand the process needed to become consistent, probably due to not having the right information in the first place but also not giving it enough time.
To really understand risk and how we have to think about it and deal with it is one major part of trading. Knowing what you are risking on each trade and how to standardize that process is something that need to be taken seriously if you are going to create a plan that works in the long run. Just guessing at the correct lot size is just not good enough and not the only factor to consider. When we place a trade we are not only risking money, we are also putting our confidence to the test. Our confidence in our trading system and our confidence in ourselves to execute on that system.
To have an accurate visualization of how risk can affect your account balance, let's conduct a basic experiment right now... What you need is very simple.. go and grab one coin, a pen and a pad of lined paper, then follow the steps below:
1. Divide the paper into 2 columns, one for wins and one for losses
2. Flip the coin 10 times and record the wins and losses in the appropriate columns. But also use the lines to separate the order. So if you get 2 wins followed by 1 losses followed by 4 wins: the first win goes on line 1, the 1 loss goes on line 2, and the 4 wins go on line 3...keep going like this until you reach 10 flips
3. Continue going in series of 10 coin flips then draw a line below each group of 10. Do this until you hit 100 flips.
4. Record the number of wins and losses over all
5. Record the number of wins and losses in every grouping of 10
6. Then count up the maximum number or wins in a row and the maximum number of losses in a row
The point it is to know what we are actually doing. A coin flip should be 50% chance of heads and 50% chance of tails, but as you can see that 50% is randomly distributed throughout the flips. It does not go 1 win 1 loss, repeat. In my experiment I got up to 6 losses in a row and 4 wins in a row and in the end was at a 49% win rate.
Thinking about this in Forex trading terms, we should be profitable with a 49% win rate if we are doing things correctly. It sounds bad doesn't it...losing more than half the time! But, if we make sure are wins are larger than our losses then we will be profitable... sounds better now doesn't it... yes I am saying that if you are WRONG more than half the time you can still make money trading! You can see this in actin using the Wealth Calculator.
We are missing one BIG key variable!!! We need to standardize our risk and keep it SMALL! Yes most new traders have a smaller account balance and are not happy with wins that equal only enough to buy a coffee or a dinner out, but we have to stop thinking of profits in terms of dollars earned and instead look at % of increase.
The other side of that equation is % risked rather than some arbitrary lot size or dollar value we are willing to use. We suggest no more than 2% of your account at risk on each trade, preferably 1% or less. Why so little you ask... well, the average new trader risks between 10% an 25% per trade. So lets rewind and look at those coin flip results again. If in my experiment, where i lost a maximum of 6 in a row, if I was risking 10% per trade. I would have lost about 60% of my account, not including transaction costs.
Take note of this fact here: If you lose 50% or your account. You need to double your account just to be back to where you started! That is daunting...
What Warren Buffett says about risk is that "Risk comes from not knowing what you are doing".
I'd say that is pretty accurate. I am hoping that that has opend your eyes to what you are risking and why we need to limit our risk and make our wins larger than our losses.
Having a plan in you Forex trading is taking this one step further and actually writing out how and why you will be doing these actions. Find out how to create your own Forex Business Plan here.
Further, here is a great article on how the man himself views risk. Business Insider
Kevin is the founder of Action-FX and has been involved in trading for over 20 years in one form or another. After going through all the bumps and bruises required to become profitable on your own, he developed an easy to follow step by step approach to trading that is clearly taught in the Action-FX trading course.
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