In the trading world, the capital we bring to the table is the raw material. If you do not have enough money to trade with, then how will you make a profit? Hence, we need to not just protect the profits that we make but also protect the capital.
Extending this thought – if you risk too much capital on any one trade, then you stand a chance to risk your capital to an extent that you may burn your capital leaving you with very little money.
Now, if you are trading with very little money, then every trade that you take will appear to be too risky. The climb back to where you started will (in terms of capital) will be a Herculean task.
I have prepared a table to help you understand this fact. Assume you have a trading capital of Rs 100,000. Let us see how the numbers stack up with-
Assume you lose 5 percent of your capital or Rs 5000. Your new starting capital is Rs 95,000. Now, in order to recover to Rs 5000 with a capital of Rs 95000, you need to generate a return of 5.3 percent, which is 0.3 percent more than what you lost.
Now, instead of 5 percent, assuming you lost 10 percent and your capital becomes Rs 90,000, now in order to recover Rs10,000 or 10 percent of your original capital, you have to earn back 11.1 percent.
As you can see, as the loss deepens, you will have to work really hard to bounce back to original starting capital. For example, at 60 percent loss or original capital, you are staring at a 150 percent bounce back.
Unfortunately, the ‘recovery trauma’ affects traders with smaller account size. Assume you come to the market with Rs 50,000 capital.
Now you would have heard of stories on how Rakesh Jhunjhunwala, grew his money from Rs 10,000 to 15K crore. You would want to replicate at least a small portion of this success.
Honestly speaking, if you can manage to grow Rs 50,000 to say Rs 60,000 by the end of the year, you would have done a great job. This translates to a 20 percent return.
But, this is not exciting, right? I mean earning Rs 10,000 over 1 year when you are actively trading somehow does not seem right.
So what do you do? You tend to take bigger risks and hope to make bigger gains, and if the trade goes against you, then you are essentially falling prey to the ‘recovery trauma’ phenomena.
This is exactly the reason why you should never risk too much on any one trade, especially if you have a small capital.
Remember, your odds of making good money in the markets is high if you can manage to stay in the game for long and to stay for a longer period, you need to have enough capital, and to have enough capital, you need to risk the right amount of money on each trade. This really boils down to working towards longer term ‘consistency’ in markets, and to be consistent you need to position size your trades really well.Disclaimer:
The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.