Law of Probability

The number one rule for any trader is "Cut your losses fast, let you profits run". I didn't really grasp this concept until recently. I was implementing this rule half-heartedly. But after reading Market Wizards: Interviews With Top Traders by Jack D. Schwager, I finally understand the logic behind this rule.

The idea of this rule is due to the law of probability. Let me try to explain here:

Let’s say the market is fair, you have a 50-50 chance of winning (ignoring brokerage). That means if you make 10 trades, you win 5 and lose 5. Let’s say you limit your losses to 10% of your invested capital and your average profit is 20% of your invested capital. If you use RM1,000.00 for every trade, then your losses will be RM500.00 and your winners will be RM1,000.00. That means you still earn RM500.00!

So do you see the idea behind this rule? Good traders know that it is okay to make a mistake. The important thing is to get out of the mistake as quick as possible. Novice traders always think that to earn from the market, you must always be right and cannot make any mistakes. But to be right always will cost you dearly!

So now I have solve my problem of cutting losses. If I don’t like the way the stock is moving, I will get out first and restrategize later. The important thing is to protect my capital.

Concerning the second part, I think I may have an answer to that. To the “anonymous” user that suggested that I should not be trading, well, I’m going to prove to you that I can make it to the big league!