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Nothing cuts to your core like blowing an account up.

Yes, now I make six figures in a month… but that wasn’t always the case.

I bared my soul for the world to see in my recent webinar. In front of thousands, I told my tale of woe…

…losing $40,243.50 trying to trade stocks.

 

 

Traders wear their stories like badges of honor…a testament to their medal.

The thing about trading is… it’s about how you bounce back and dig yourself out of the hole. You see, no matter where your PnL, it can take a wild turn.

Let me tell you something losses, you never want to go through that grueling mental pain.

I send out these letters every week hoping you heed the advice to prevent that from happening.

No one needs to go through that pain – not a single one of you.

Do me a favor and at minimum incorporate the 5% rule into your trading.

What’s the 5% rule and how can it benefit your trading?

 

What is the 5% rule?

 

There will always be an element of risk involved when trading. You don’t need to let that risk define you. 

Risk management works like meditation. You learn to accept the risk, own it, and make it a part of you.

And where there is risk, there is the 5% rule to assist with risk management.

Let’s say $1,000 fell your way- won it in a raffle or a small inheritance. You decide to invest it.

Do you risk it all at once or spread it out over hundreds of tiny trades? There has to be some balance…the 5% rule.

The 5% rule limits your exposure on any one trade to 5% of your total account. With $1,000 you limit your maximum losses to $50 per trade. 

This way if you lose on 1 of the 20 trades you made with your money that loss is only 5%. 

Why is this important?

 

You want your risk spread out like soaking up sun on vacation, ensuring you don’t get burned. 

With the 5% rule, you are essentially lowering your risks by investing in a few different areas of the markets, diversifying your investments. Divvying up your trades protects your portfolio from being negatively affected by any single factor.

All this relies on the Law of Large Numbers.

The law states that the more events (trades) taken, the more likely the outcomes will converge on expected value.

Imagine you flipped a coin. Heads gets you $1. Tails loses $0.50. We know there’s a 50/50 shot of each.

Let’s play this out over 10 events.

  1. Win $1 
  2. Lose $0.50
  3. Win $1 
  4. Lose $0.50
  5. Win $1 
  6. Lose $0.50
  7. Win $1 
  8. Lose $0.50
  9. Win $1 
  10. Lose $0.50

 

By the end, you made $2.50 over 10 turns. That gives you $2.50 / 10 turns = $0.25 per turn.

This is your expected value.

The formula for expected value is as follows:

Expected Value = (% chance of winning x amount for winning) – (% chance of losing x amount for losing)

In this case, your expected value works out to be $0.50.

Expected Value = (50% x $1) – (50% x $0.50) = $2.50

We all know that life doesn’t work that exact. Sometimes you flip heads 5x in a row. However, if we keep flipping the coin heads should show up 50% of the time.

This is exactly why you don’t want to put all your eggs in one basket with one trade. You could pick the best trade ever and still lose. 

But, if you limit your losses and keep making the same trade over and over, eventually, you come out on top.

 

Risk of Ruin

 

The 2011 movie Margin Call illustrates the Risk of Ruin beautifully. The plot centers around am investment bank who’s access leverage left them in solvent. Their overexposure meant their losses exceed the worth of the entire firm.

No trader should be destroyed by one or two trades. Trading requires time to turn a profit. That’s why the 5% rule reduces the risk of ruin. 

The risk of ruin comes from any one trade or investment destroying your account. This doesn’t mean your account goes to zero. If your strategy uses margin to trade, any trade that puts you below the minimum to use margin effectively ruined your account.

Note: Most brokers require $2,000 to trade on margin. You need margin to trade option spreads or short stocks.

So, if your account has $2,500, and you require margin, you only consider the $500 cushion above $2,000 as your bankroll. From there, only trade with 5% of the $500, not $2,000.

Risk management dictates success for traders more than any other factor. Make it a key focal point of your work.

If you didn’t get a chance, check out my free article on option strategies for your retirement accounts. It highlights two great ways to manage risk.

Click here to read the article

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