As traders, one of our most important responsibilities is to define both our trading float as well as our trade loss limits. Of course, our trade loss is essentially the maximum amount of money we’re willing to loose as a result of any one trade we make. By defining these parameters we not only ensure losses are kept at a bare minimum, but we all protect ourselves against the effects of multiple losses occurring one after the other.

Unacceptably high risks are the primary reason for so many traders failing. Remember, the objective here is to keep losses at a minimum while at the same time allowing ourselves enough room for profits.

A very famous cricket captain once said that the most important aspect of the game, is not to make runs, but to stay in the game. I mention this because it’s so true with regards to trading as well. Your primary goal should be for you to protect your trading float just as that captain sought to protect his wickets. If you loose your float, you’re out of the game.

Always being aware of the maximum loss I’m willing to accept, doesn’t mean I’m negative. Instead, because I employ a meaningful trading psychology, I’ve learnt to be on the defensive at all times. After all, it’s all about survival.

Being a firm believer in keeping trading losses to a minimum, a top trader by the name of Ed Seykota once defined the 3 elements of trading. He said,”Follow these three rules and you just have a chance”, 1) Cut your losses, 2) Cut your losses and 3) Cut your losses.

Whether you like to believe it or not, you will experience losses along the way and there is nothing you or I can do to avoid them. However, the trick is to accept them and then to move on. Whatever you do, never allow losses to obscure your better judgment because in trading, keeping a clear head is vital.

In all probability, you’re more than likely wandering how to define your maximum trade loss? Generally speaking, many traders tend to follow what’s known as the “2% Rule”, meaning you should never risk more than 2% on any given trade. However, many of the more seasoned professionals disagree with this as they feel it’s too high. Instead, these traders like to cap their maximum trade loss at 1% or lower. Admittedly, such a low maximum trade loss means no one single loss will have any noticeable impact on you but at the same time, your profits will also be low.

Perhaps a better way of putting the 2% rule into perspective would be for me to use an example. So, let’s say we start out with a float of $20,000 to which we apply the 2% rule. In this case our maximum loss on any given trade would be $400. As you can see, with your losses kept this low, it would take many losses to erode your float completely.

In fact, we would need to experience no less than fifty consecutive losses before loosing our entire float. Of course, you don’t need me to tell you just how unlikely it is that you’ll experience 50 losses in a row. Furthermore, because the 2% rule actually uses the current float amount rather than the initial float amount, you would need even more than fifty losses before being broke.

Let’s take a look at this in practice:

As I’ve mentioned, when the 2% rule is applied correctly, using your current float amount, the maximum loss amount will decrease as your float decreases. For example, once again using the $20K float mentioned above, a second loss would equate to a maximum trade loss of $392, this being 2% of the $19,000 you had remaining after your first initial loss. If you experience a string of six losses in this manner, then your float would decrease as follows:

Float amount: $20,000
Float after 1st loss: $19,600
Float after 2nd loss: $19,208
Float after 3rd loss: $18,824
Float after 4th loss: $18,447
Float after 5th loss: $18,079
Float after 6th loss: $17,717

$17,717 still in the float even after we’ve experienced six losses in a row is something we can be proud off because it shows that we’re minimizing trade losses effectively. As I’m sure you’ll agree, this is exactly what risk management is all about.

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