Risks in Trading.

Brett Steenbarger, Ph.D, in his excellent blog writes:

“A while back, a trader told me he was doubling his money each year in the market and asked if I wanted to invest funds with him. I immediately declined. My rule is that, over time, a trader will always draw down at least half of his or her targeted return rate. Anyone who guns for 100% returns annually will surely, at some point, experience a 50% drawdown. That’s not for me.

Risk and reward are always proportional. Those who understood that did not invest with Madoff.

I know from experience that, at some point over time, I will draw down 10 times what I’m willing to risk on a single trade. If I risk one percent of my capital in a trade, I’d better be prepared to endure a 10% drawdown in capital at some point in the future. If I risk 5% of my capital in each trade, I’ll eventually lose at least half of my money. Probability and psychology guarantee slumps; wise traders plan for them.
So much of trading success is knowing how to lose.”

My Notes: If you want more rewards, you have to take more risk. A desire for large returns invariables leads to big losses and destroys your trading capital (and your mental peace). But novices never believe this because they have not seen this process in action.

Traders should look at the percentage return they receive from trading. If they are getting 20%+ per annum they are doing well. Looking at percentages keeps expectations at a realistic level and avoids unneccessary risk.

I have an example from my own business: We have a service called Day Vinayak which provides day trading signals. All trades are closed at the end of the day. The big advantage is: no overnight risk. This also means that margin requirements are low, so capital requied is less. Sounds like a dream? Not really. This Monday when the Nifty fell 170 points, Day Vinayak had a dream run. Since then, in the past three days it has given back 35% of profits made on Monday. Maybe it will give back more. For traders it is disturbing to see big profits come in and then maybe 80% of it go away. But that is the way a long term approach to trading works. The fact is that the 20% that remains is also a handsome return on capital invested. Now comes the main point. Chances are that the service may earn 50% (after costs) over a one year period. But if you start with Rs 2 lakhs and want to use the profits as a source of meeting your family expenses, then the annual income will be Rs 1 lakh which is not enough. If you start with Rs 5 lakhs, and, this is your spare money meaning you do not need the money for your personal expenses, you may end up with a gain of Rs 2.5 or Rs 3 lakhs – an excellent return on capital.

I have given a lengthy example from a real life trading scenario to share with you what short term trading gives you.