In the last couple of articles, I've been writing about some of the things that I believe are critical elements to good trading. Last weekend, I wrote about some general requirements -- knowledge, plan, discipline and patience -- that I would suggest can be critical factors in successful trading. In this article, I am going to discuss a triumvirate of elements that I believe are also extremely important in attempting to achieve success in trading. They are exit strategy, reward to risk ratio, and money management.
In most cases we can't know how we've done in a trade, whether we've made a gain or suffered a loss, until the trade has ended. In other words, success or failure is ultimately determined by the exit. Until then, anything could happen. It seems pretty clear, then, that the exit is one of the more important things we can do. The next question for me is when should I formulate my exit strategy? My answer is that I should have my strategy in place even before I enter a position and then have the discipline to adhere to the strategy.
Reward to risk can definitely separate the winners from the losers. A trader who consistently enters trades with a 1:1 reward to risk (meaning he is risking a dollar to make a dollar) might well be doomed to ultimate failure if he is right on 50% of his trades. He will win a dollar, lose a dollar, win a dollar, lose a dollar, etc. and be around breakeven except he would be paying a commission on every trade and ultimately run out of money from paying commissions. On the other hand, finding candidates where the potential reward appears to be 2 and 1/2 times (or greater) than the risk (2.5:1) would permit the trader to lose 7 out of 10 trades and still wind up with a modest profit.
Of course, the reward to risk can work assuming that the trader's plan include some method for money management. If money is invested without thought to management, the trader runs the risk of things like seeing the larger positions lose and smaller positions wind up as winners or being wiped out by a single loss or having one loss erase a series of wins. The trader who incorporates money management in his plan has a much better chance of staying in the game and may well increase his chances of overall success. Failure to incorporate an element of money management can expose the trader to some serious additional risk.
For those who are interested, detailed discussion of much of what I have written in the last three articles can be found in my first book, "Trade Your Way to Wealth."
by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved
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