A golden rule of trading is don't bet the house. In other words, minimize your trading risk.
One of the cardinal sins for anyone trading is to use money that isn't trading risk-capital. That is, you use money for trading that you can't afford to lose, money that if lost will affect your lifestyle and perhaps your ability to provide for your family. Using risk-capital creates tremendous emotional pressure in you, even before you enter your first trade. The less trading risk the easier it is to get into the right trading mindset.
If you're dependent on the capital you're trading, it will be nearly impossible to remain objective and to think clearly, and when trading you must remain detached from the individual trades. Clearly, if your livelihood is riding on each trade, every losing trade will amplify the pressure and further distort your thinking. The probability that you'll be wiped out and substantially hurt is heightened.
Trading risk capital also sets you up for many additional emotional traps that are likely to sink your ship. Let's go over a few.
One emotional trap is that when you trade money that you need to support yourself you are likely to be in a hurry to make money. You're impatient to hit that home run and so you'll start to work with less than favorable probabilities. Soon, you might even start taking trades with the odds against you. You'll get attached to trades, hang on to them, ride them too long, because of wishful thinking. Worried about making your next mortgage payment, you soon forget to keep it realistic. If it's only a single, you won't take the single, hoping for a home run. You've forgotten that the markets answer to no one. If you try to force a home run, you'll soon be tagged out.
Another trap that comes right in with trading risk capital is trading without a plan, the most common mistake made by losing traders. By not having a plan, you create a tremendous amount of uncertainty. This adds to the numerous emotional influences that cause bad decisions.
Trading without a plan means trading without decision guidelines in place. Without knowing in advance what you will do after the trade commences. The plan is what allows you to minimize your losses and capitalize on winners. The trading plan also lets you know whether or not you've entered a trade with a reasonable probability of profiting.
I once entered a bull call spread on the Euro, a small trade, and it
seemed conservative enough. I didn't bother to follow my normal practice of calculating break-even and other important numbers
before I entered the trade. I did it immediately afterward, but that was a stupid mistake. As soon as I sat down and did the simple math, it was apparent that the price would have to be in a very tight range on the day of expiration in order for me to make a profit. All the other scenarios resulted in a substantial loss, which is exactly what I got. $3,000 out the window.
Defining your trade goes hand in hand with planning your trade. If you don't define a specific target and stoploss for each trade, you've limited the exit points that benefit your account and you've increased the chances that you'll stay too long waiting for a price to come back.
Finally when trading risk capital, you're much more likely to over-trade your account both in size and frequency. Having the patience to only enter trades when the timing is right is critical. If you feel the need to make more money, or to make up for lost ground, it's tempting to get into too many trades, take too large trades (ignoring basic risk mismanagement), or to just plain trade too often. With the advent of online trading and 24-hour markets, some traders feel compelled to trade so much that it has completely unbalanced their lives.
Remember, you're trading to have a life, not the other way around. And if you burn yourself out mentally or physically, it will eventually take its toll on your trading success.
So never use money for trading that you can't afford to lose. Too much trade risk will exert tremendous emotional pressure on you that will affect your trading and ultimately your lifestyle. By making it difficult to remain objective and think clearly it causes you to make many mistakes, increasing the probability that you'll be wiped out. And getting an edge is all about minimizing trading risk and in the process getting probabilities on your side.
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