The Mathematics of Trading and Commissions
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Nothing supports the reasoning for not overtrading more than a look
into the mathematics of what it takes to recover from the previous
losing trade. Table 3.3 shows the percentage gain necessary to
recover from a predetermined percentage loss. It is based on your
initial investment capital. The obvious message from the table is that
losses must be cut quickly. If not, they increase at a geometric rate.
The potential for loss is accelerated when leverage is used
(margin, options, futures). It has been my experience that it is
extremely difficult to recover from any loss of capital below 25 per-
Table 3.3 Recovering from a losing trade
Percent Loss of Capital Percent Gain Required to Recover
5
10
15
20
25
30
35
40
45
50
55
60
5.3
11.1
17.6
25.0
33.3
42.9
53.8
66.7
81.8
100.0
120.0
150.0
cent. If you are using margin, and you have two trades that are down
20 percent, you must make more than 100 percent on the next two
trades. Remember, you will have commission and slippage, which
means that you need far more than 100 percent to break even. Risk
and money management are of paramount importance to your success.
I have known traders who have had 10 consecutive winning
trades and lost it all by not managing the risk on two trades. When
you enter a trade you become a risk manager; you are no longer a
trader. Never forget this.
If you are scalping and making 30 or more trades a day, you had
better be right almost all the time. Because of the number of trades
you are making, your margin of error has to be very small. You can't
afford to be wrong very often. Imagine, if you will, 5, 6, or 10 losing
trades in a row. Who says a winning trade has to be followed by
another winning trade? Every trader knows that a series of losses
can happen at any time. Using Table 3.3, calculate what just three
losing trades will do to you. Then figure the percentage of the
impact if those trades are margin trades. Ouch! This information
isn't in your account statement. Some traders reading this book
right now are looking at their account statement and believe that
they are making lots of money. In reality, they are already dead but
they don't know it. Only drawdown analysis and creating an equity
line will show you how good you really are as a trader. (See Trading
the Plan by Deel.) You will never eliminate losses, but you should try
to control drawdown. Your goal should be to never have a drawdown
below 12 percent. This may be difficult to accomplish, but
you should try to achieve this goal. This will force you to become a
risk manager on every trade. What about commissions?
Nothing supports the reasoning for not overtrading more than a look
into the mathematics of what it takes to recover from the previous
losing trade. Table 3.3 shows the percentage gain necessary to
recover from a predetermined percentage loss. It is based on your
initial investment capital. The obvious message from the table is that
losses must be cut quickly. If not, they increase at a geometric rate.
The potential for loss is accelerated when leverage is used
(margin, options, futures). It has been my experience that it is
extremely difficult to recover from any loss of capital below 25 per-
Table 3.3 Recovering from a losing trade
Percent Loss of Capital Percent Gain Required to Recover
5
10
15
20
25
30
35
40
45
50
55
60
5.3
11.1
17.6
25.0
33.3
42.9
53.8
66.7
81.8
100.0
120.0
150.0
cent. If you are using margin, and you have two trades that are down
20 percent, you must make more than 100 percent on the next two
trades. Remember, you will have commission and slippage, which
means that you need far more than 100 percent to break even. Risk
and money management are of paramount importance to your success.
I have known traders who have had 10 consecutive winning
trades and lost it all by not managing the risk on two trades. When
you enter a trade you become a risk manager; you are no longer a
trader. Never forget this.
If you are scalping and making 30 or more trades a day, you had
better be right almost all the time. Because of the number of trades
you are making, your margin of error has to be very small. You can't
afford to be wrong very often. Imagine, if you will, 5, 6, or 10 losing
trades in a row. Who says a winning trade has to be followed by
another winning trade? Every trader knows that a series of losses
can happen at any time. Using Table 3.3, calculate what just three
losing trades will do to you. Then figure the percentage of the
impact if those trades are margin trades. Ouch! This information
isn't in your account statement. Some traders reading this book
right now are looking at their account statement and believe that
they are making lots of money. In reality, they are already dead but
they don't know it. Only drawdown analysis and creating an equity
line will show you how good you really are as a trader. (See Trading
the Plan by Deel.) You will never eliminate losses, but you should try
to control drawdown. Your goal should be to never have a drawdown
below 12 percent. This may be difficult to accomplish, but
you should try to achieve this goal. This will force you to become a
risk manager on every trade. What about commissions?