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Risk, Compounding & Psychology

5dmin January 10, 2020

One of the most important aspects of trading is managing your risk.

There are 2 different types of risk though.

Capital Risk & Mental Risk

The first 1 is managing the capital you are trading with.

If you take your trading account from $X to $0 then you have no more capital to trade with, and will be sitting on the sidelines until you are able to fund your trading account again. The silver lining in this is that you can almost always make more capital to fund your account with. It may not be by doing something you want to do like cutting grass, shoveling snow, driving uber, or whatever it may take. It goes without saying that we want to try and avoid this at all costs, so what do we do?

We have to put parameters in place so that we don’t blow our account up, and stick to those rules.

1 way we can do this is by setting a % of risk from our overall account on a per trade basis.

Example: Let’s say we have a $1,000 account and we set a 5% risk cap per trade so we can not risk more than $50 per trade.

Another way we can do this is by setting a % of total capital that we are allowed to put into a position.

Example. Let’s say we have a $1,000 account and we set a 10% capital allocation in a single trade. This means that we would not be allowed to put more than $100 into a trade. With Nadex this would also give us a cap on the potential loss for the trade since they are defined risk.

Mental Risk

^ This is absolutely crucial. If you lose what I like to call your ‘Mental Capital’ then it is harder to recover from than losing actual capital.

As we all know trading is 90% mindset and 10% of everything else.

A few things to avoid:
Over Trading
Revenge Trading
Emotional Trading
Focusing on P/L
“The Market Owes Me”
Using capital you can’t afford to lose.

Later in this section I will cover more on Psychology, and some helpful resources so that we can protect our mental capital.

Compounding

Nadex is an absolute amazing product when it comes to putting compound interest to work in your favor…if you use it correctly, of course.

Here are a few of my favorite quotes about Compound Interest.

“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” – Albert Einstein

“Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market.” – Warren Buffett

“If you understand compound interest, you basically understand the universe.” – Robert Breault

Why is compound interest so important and how does it apply to Nadex?

Well let’s take a look at the screenshot below.

We all know there are 52 weeks in a year. In this example I’m only going to use 20 weeks though. Why? Well much like with everything let’s just say there are some weeks where we don’t trade, and there are some weeks that end up just averaging out. (We lose some $ this week, and make some $ this week, but it evens out)

If there are 20 good weeks though throughout the year where we are able to grow our account here is what’s possible. These numbers can obviously be tweaked to fit each individuals specific risk parameters and what they are comfortable with.

In weeks 1-10 we are looking to grow our account by an average of 25%. This would take a $1,000 account up to $9,313 by the end of the 10th week.

Then in weeks 11-15 we step it up and have some killer weeks where we grow our account by 50% and in just those 5 weeks we scale our account from $9,313 to over $70,000.

We now have a more sizeable trading account, so we start to scale back our size and in weeks 16-20 we only go for 10% growth, and after starting with just a $1,000 trading account we have now grown it into over $113.899.

These numbers are of course for demonstration purposes you aren’t going to hit exactly these numbers to the dime, but the point still remains the same. At the end of the day “Trading is a marathon, not a sprint.” – Eric Marcus

Psychology

The market not only doesn’t care about you. The market doesn’t even know who you are.

^ Remember this.

The market isn’t going to be nice to you, and the only person who is going to take care of you, is you.

It also doesn’t matter what you do in your ‘real life’ whether you are a doctor, engineer, truck driver, sous-chef, or a pilot. Every trader will experience the same struggles, but it is how you adapt and overcome those that writes your success story. Watch the short video below to hear my thoughts on what can help you control your emotions and repair any already cracked psychological state you might be in.

> Reminiscences of a Stock Operator <

> Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude <

> The Disciplined Trader: Developing Winning Attitudes <

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