There is a common belief in Forex trading, or any sort of trading that if you lost 50% of your trading account, all you'd need to do was make 50% and you'd be back to break-even.
This is not actually true. Suppose you start with $ 10,000. You lose 50% of this and are left with $ 5,000.
You will now need to make $ 5,000 off a trading capital of $ 5,000. This means that you need to have $ 5,000 / $ 5,000 = 100% performance to get back to break-even.
So, for every percentage point you lose, you need to make more in percentage terms to get back to break-even. This is often referred to as a "loss hole". You've dug and fallen into a hole of your trading losses and now need to get yourself out of it.
The Psychological Perspective of the Loss Hole
From a psychological point of view this is crucial. From the above example, you've got to double the size of your account just to break even. That is not psychologically easy or practicable easy to do. 100% performance in any given year is a performance figure many traders would give their right arm to have, and if you are new to trading, these types of performance figures only come after some time learning the markets.
However, anyone who's done any trading will tell you that losing 50% of your account is very easy to do. It does not require talent and dedication to lose 50% whereas it requires to make 100%. Whilst it is possible to do this trading treaties, it is by no means easy
You are also going to be stuck in a negative frame of mind, you'll be trading to not make a loss , ie break even sooner than trading for profit, and the difference between these two mindsets is immense. Negative mind-states are very detrimental to trading and you should avoid them at all costs. Playing to not lose is VERY different from playing to win.
So we can conclude that once you have fallen into a loss hole, it is much, much harder to claw your way back out of it.
How Can I Prevent This?
Prevention is better than cure, the best way to never have to dig yourself out of a big hole is to never fall into that hole in the first place. Here are five things you can do to minimize the chances of digging your very own hole hole:
– Stick to the 1% rule – NEVER risk more than 1% on any one trade. Make sure that the amount you will lose if the price hits your stop loss is always 1% or less of the value of your total market capital. This minimizes the chance of ruin, ie the chance that you will lose all your money.
– Never risk more than 2% of your total capital at any one time – If you're following the 1% rule above this means that you should never have more than 2 trades with 1% risk on them, or four trades with 0.5% on them. This ensures that you will never lose more than 2% of your account in one go should the markets turn against you.
– Have a loss cutoff rule – You should stop trading if you have three losers in a row. Make sure that if you start sustaining losses you take a break, re-frame yourself and come back to trading with a fresher perspective.
– Have a strategy with a positive expectation – The best way to win is to not lose, ensuring that the trading system that you are using will make money in the long run provided you apply it consistently.
Any Exceptions To This?
Every rules have their exceptions, and there are many ways to skin the trading cat.
Some very successful strategies such as those used by Richard Dennis's Turtles can lose up to 50% of their account before they make a lot of money, those strategies lose often, but when they win they win very big.
If you know this is what your strategy does, then you will be expecting that loss, and you will also know that you need to follow your strategy to make your money back and profits on top of it.
If you do NOT know what your strategy's maximum drawdown is, you really need to find this out before you start trading it, as it's not clear how big the hole you may dig for yourself is.
So in conclusion, taking losses, especially taking a series of big losses is more dangerous to your account than you might think.