Never try to win back a lost trade

Most traders only think about one thing:

Penke

“Making as much money as possible in a short period of time”

Because making money is the one and only reason to get into trading or investing, people make many mistakes. The biggest emotional mistakes you can make are:

  • Investing with money you can’t lose
  • Investing with money you need in the future
  • Trying to win back bad trades
  • Using leverage products

There is no fixed amount of money you need to have before you can invest. Although some assets require an x amount of money before you can buy them. How much money you need also depends on what kind of investor you want to be. If you don’t have any money to invest, then simply don’t invest. If you do, you will get emotional sooner or later and make mistakes. Even if you see the biggest opportunity in your life, you simply can't invest the money you currently need. Because no matter how big the opportunity is, you will never have a 100% guarantee that it will be a success. That's why it’s very important to first apply the basic rules of money management to your finances. If you apply these rules, you will always end up with money you can spend on whatever you want.

If you use the money you need right now, you'll be emotionally attached to your trades. If you lose a trade, you will get a very strong emotional reaction and you need to win back that trade. If not, you can't pay your bills anymore. You will desperately try to win back your money. But what most traders don't realise is that you need to win back even more money than you lost to get break even. 

Quest: Break even

If you started with $1000 and lost 50% in a trade gone bad, how much % do you need to win back to get break even (back to $1000)?

Reward:  +10 XP  0   0   0

Let's assume you have $2000 and take a trading position for 50% ($1000):

  • You put $1000 in one trade and lose the trade
  • You lost 50% of your initial stack ($1000 from the initial $2000)
  • That does not mean you need to win back 50% to get break even
  • If you have $2000 and lost $1000 you have $1000 left
  • If you win back 50% of $1000 you only get $500. To get break even you need to gain 100%!
If you lose: You need to gain for break even:
10% 11.11%
20% 25.00%
30% 42.86%
40% 66.67%
50% 100%
75% 300%
90% 900%

You can imagine that things will go bad very fast if you try to win back money you lost. You simply need to gain much more after a losing trade to get break even. That’s why you should never get emotionally attached to a trade. If you lose a trade:

  • Forget about it
  • Stick to your plan
  • Don’t be greedy by trying to win back the money you lost

And the same thing applies if you are in a winning trade:

  • Stick to your plan
  • Don’t be greedy, take your profits

2.1 The eight wonder of the world: compound interest

Investing is all about compound interest. Albert Einstein once said:

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

It really starts to get interesting when you look at compound interest. Compound interest means you reinvest the interest you received on your investment. An example:

If you invest $10.000 with an annual gain of 10% you will have $11.000 at the end of the first year. If you take your profits of $1000 out you will have $10.000 in cash and $1000 in profits. If you take out $1000 for the next ten years (assuming you will gain 10% each year) you will have:

  • $10.000 in cash
  • $10.000 profit

When using compound interest, you'll reinvest the profits. The first year you will earn $1000 in profits. You now have $11.000 in assets. In the second year you will not gain $1000 but $1100. If you re invest the gains for the next ten years (assuming you will gain 10% each year) you will have:

Year Initial investment Total value
0 $10.000 $10.000
1 $10.000 $11.000
2 $11.000 $12.100
3 $12.100 $13.310
4 $13.310 $14.641
5 $14.641 $16.105
6 $16.105 $17.715
7 $17.751 $19.487
8 $19.487 $21.435
9 $21.435 $23.579
10 $23.579 $25.937

After ten years you will have:

  •  A total $25.937 in assets
  • $15.937 in profits

The magic of compound interest is that you gain profits over the interest you gained in the previous year. Meaning your gains will grow exponentially when time passes. That’s why you should think about money you invest as something you can't touch for the next ten or twenty years. You can’t do this with money you need right now or in the short future. If you are in for the fast money and using the profits for other things you will not benefit from compound interest.

The above example is based on an initial investment of $10.000. Now imagine what will happen when you not only reinvest the interest you receive but also invest an extra $500 each month for the next 10 years:

  • Initial investment: $10.000
  • Monthly investment: $500
  • Total investment after 10 years: $70.000
  • Total value after ten years with 10% interest: $121.561,97
  • Total gain: $51.561,97

Compound interest is one of the biggest factors of solid returns in the long term. Even if you only have small amounts of money to invest each month, in the long run (ten or twenty years) compound interest will certainly add up. But this only works when you don’t take out any profits. As you can imagine, many people will take profits at some point. Because they need the money or they just want to buy something like a new car. This destroys the compound interest in the long run. That’s why it’s very important to determine what kind of trader you want to be and what exactly your goals are. We will discuss this in “Decide what kind of investor you want to be”

 

2.3 Cash on the side

It’s very important to understand that there will be times that you simply should not invest. This depends on your trading strategy. For example, when stocks are very overpriced it might be best to stay in cash. Cash is very important because cash allows you to take positions regardless if the market is good or bad. You should always have some percentage of your assets in cash. At some point in time markets will collapse. This happened multiple times in the last 20 years. There were very big drops in the market. The funny thing is, almost everyone thinks these drops are bad and people start selling. But these are the exact moments when a pile of cash can give you the opportunity to buy in low. This is not possible if you have no spare money on the side. These events only happen a few times in a decade. Some examples:

  • Internet bubble 2000
  • Financial crisis 2008
  • Covid-19 pandemic 2020

Market crashS&P 500

And although you can never time the market, at some point you will notice patterns. The most recent event during this time of writing is the Covid-19 pandemic. As soon as every newspaper was talking about Covid-19 infections, sick people and deaths markets all around the world plummeted. When newspapers are flooding with bad news, then it's worth to taking closer look.

The S&P 500 was skyrocketing at the time reaching all time highs of $3400 early 2020. When Covid was here, in just two months the S&P 500 plummeted to $2200. This was the biggest drop in history of the S&P 500. As an investor, as weird as it may sound, this is very promising news. Because of the simple fact that you can now buy the S&P 500 for $2200 instead of $3400 two months earlier. Just 1.5 years later, the S&P 500 is now (july 2021) trading for $4400. You now have 100% profit for all the stocks you could buy at $2200. That’s a big amount of profit for assets like the S&P 500. Although it’s impossible to buy at exactly the lowest point and sell at the highest peak. You will learn more about this later on. But in theory you could make 100% profit by just reading the news and watching the sentiment on the market.

These are the exact moments you wish you had some cash (that you don’t need) to invest and gain profits in troubling markets. You should always do your own research on patterns because markets are mostly emotional driven. If you can spot trends in emotional events you can profit from them. While it might be a good idea to have some cash on the side for these big emotional events, you also might lose money. For example:

Basline marketcrashS&P 500

Let's imagine you start investing in 2014 (first green arrow). At that moment in time, the S&P 500 reached its highest price in history. The highest tops before that were in the year 2000 and 2008. If you have a pile of cash waiting for an opportunity you have to wait all the way up to the end of 2018. But even the lowest low in 2018 is much higher than the starting price in 2014. Although you could buy relatively cheap in 2018, you still lost money if you would just invest it all in 2014.

There actually is no best moment to jump in the stock market. The right time is now. Because you will never know what will happen next. The market could double in the next 10 years like it did the last decade. We could also face ten years of despair due to new Covid-19 variants. Who knows…If you manage your personal finances correctly, you will always have money. And you can always decide to use this money for your investments. Depending on what you are trying to achieve. The best thing to always remember is that you can’t time the market. 

2.4 Using leverage products

One thing you should avoid at all costs are leveraging products. These products are very dangerous. Countless traders are financially ruined because they used leverage. It’s very safe to say that no beginning trader should ever use leverage products. Only experienced traders that know exactly what they are doing should use leverage. Leverage is the use of borrowed funds to increase your position which would not be possible with your own funds. You are borrowing money / assets from someone else. This can go up to 100 times your initial value. If you have $1000 in cash and use 100x leverage you now are trading with $100.000. 

Leveraging is a double edged sword. Although it seems that you can have very high profits with a relatively small investment, this also means that you can lose a lot of money. Because if you lose borrowed money, you also have to pay that back! You don’t only lose your initial investment, you also have to pay back the losses. Although there are some brokers (like BitMex) that allow you to make leverage trades, you can only lose the total balance of your account. You can imagine this can go bad very quickly when you use high amounts of leverage. Leverage is a very dangerous instrument and should not be taken lightly. People have killed themselves because they did not understand how leverage works and just clicked on the highest leverage available. The losses can build up to hundreds of thousands pretty quickly.

This does not mean leverage cannot be used safely. It actually is a very nice tool if you know how leverage works. Leverage is all about risk management. You have to calculate your exact entry and exit points based on your initial stack and the amount of risk (in %) you want to take. And you have to manage the risk/reward ratio with the amount of leverage and placing stop-losses. Besides, you cannot always use leverage if your stack/position does not allow it. We will discuss how leverage works in another article. For now, if you read anything about leverage just stay away. It’s an advanced product that hardly anyone truly understands. 

Products that are using leverage include:

  • Some bitcoin brokers
  • CFD’s
  • Forex
  • Options
  • Futures

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