Mathematical reason for cutting losses quickly

19 Jun

Let me tell you a bad news. Losses are inevitable. You are sure to loss some amount of money in your trading journey. If you think otherwise, then trading is definitely not suitable for you because 100% profits all the time is an illusion. However, the good news is that we can manage our losses in such as way it will not destroy us. In trading, we often times hear that we should let our winners run and cut our losses quickly. For most of us, we know it in our heads but not in our hearts. We human are creatures of hope and that is the main reason we are able to survive no matter how tough the situation is. However this habit of hoping is not good for trading. That is the main reason why many people are not successful with trading as a profession. Today we will look from the perspective of mathematics and see why we need to cut losses quickly.

Capital preservation is the utmost important matter in trading. It is even more important than making money. If we are able to consistently control the frequency of losses and the monetary amount of losses then we are set to make money. Take care of the losses and the profits will come. As Warren Buffett said it "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1". Let us start by giving an example of $100,000 as a start of trading capital and we trade 100% of our trading capital.

Money Management: Scenario 1
Initial Trading Capital: $100,000
Losses: 10% ($10,000)
Trading Capital after Losses: $90,000
Amount of Profits needed to Break Even: $10,000
Percentage of Profits needed to Break Even: 11.1%

Money Management: Scenario 2
Initial Trading Capital: $100,000
Losses: 20% ($20,000)
Trading Capital after Losses: $80,000
Amount of Profits needed to Break Even: $20,000
Percentage of Profits needed to Break Even: 25%

Money Management: Scenario 3
Initial Trading Capital: $100,000
Losses: 50% ($50,000)
Trading Capital after Losses: $50,000
Amount of Profits needed to Break Even: $50,000
Percentage of Profits needed to Break Even: 100%

Money Management: Scenario 4
Initial Trading Capital: $100,000
Losses: 75% ($75,000)
Trading Capital after Losses: $25,000
Amount of Profits needed to Break Even: $75,000
Percentage of Profits needed to Break Even: 300%

As you can see from the above example that the more you lose in terms of percentage of your trading capital, then the more percentage of profits will be required for you to get back to where you started. You see we are not talking about making money yet. As in scenario 4, you would have to see your shares prices soar by 300% and yet you are not smiling on your way to bank because you are not making money yet. All this is about money management.

Cut your losses quickly before it compounds into big financial disaster that is beyond your ability to manage. Besides that you can also gain sound sleep at night without worry of the amount that you have lost in share market. Naturally confidence will step in when our losses are small and our profits are huge. Trust me; it is not easy because we human tend to hope that the shares bounce back before we sell our losers. Start today by learning to cut losses quickly when we are wrong.

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