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How Much Do You Want To Make?
One of my favorite traders of all time is Paul Tudor Jones. In a business that destroys most money manager within three years he has survived for more than thirty trading on nothing more than his wits and an iron-clad risk discipline.
In an interview with Jack Schwager a long time ago Mr. Jones offered a very simple formula for success that we should all adopt. Ha said that traders can consider themselves successful if their drawdowns are no more than one half of their valley to peak gains. Put simply that means if your account has increased by 1000 points over say a course of 3 months then you cannot give more than 500 points back to the market if you want to maintain long term success.
I love the simplicity of this idea because it eliminates a massive amount of unnecessary math and provides a realistic business plan for trading the markets. It also creates a proper set of expectations. Want to make 100%? Then be prepared to lose at least 50% of your capital. Think about that for a second. This is a formula for success -- not failure -- and yet it shows that even under the best of circumstances we must be willing to lose half of our money if we want a chance to double it.
This rule of thumb is particularly important to FX traders who regularly use high levels of leverage because it helps explain why most traders fail miserably. If you ask traders what’s the maximum percentage of capital they are willing to lose most will answer no more than 20%. Yet the reality is that if you are trading on 10 times leverage and are shooting for 10% cash on cash return (which at 10:1 lever factor translates to 100% gain or a doubling of your account) then you should be happy to lose only 50% of you stake. Of course no one is happy to lose 50% yet everyone wants to double their money and therein lies the problem for anyone who trades speculative instruments.
The answer to how much do you want to make depends on how much are you willing to lose. If you don’t have a realistic assessment of risk before you put your capital in play you will never succeed in trading.