Last Updated on 7 September, 2021 by Samuelsson
It is common knowledge that the majority of retail traders lose money in trading. In fact, some financial websites even go as far as to claim that more than 90% of retail traders lose money and end up quitting. And this is not specific to a particular market: most retail traders in various financial markets — stock, forex, futures, and cryptocurrency markets — lose their trading capital and end up quitting.
In this post, we will be discussing the major reasons why traders lose money so you learn how to avoid them in order to make your trading journey a fulfilling one.
Poor money management
Talking about investing in the financial markets, the Oracle of Omaha, Warren Buffet, once said: “The first rule of this game is to protect your capital, and the second rule is to never forget the first rule.” On his part, the legendary trader, Ed Seykota had this to say about trading: “The key to long-term survival and prosperity has a lot to do with the money management techniques incorporated into the technical system.”
These statements from the legends show that one of the most common reasons traders and investors fail is poor money management. But what is money management? Well, it is what determines how much of your trading capital you commit to each trade. In essence, it determines your position size and, by extension, the amount of leverage — the use of borrowed capital to increase the potential return from a trade — you are using in a trade. This is why in markets that require a small margin (the minimum deposit required to borrow money from a broker), such as the forex market, many traders come in with their little capital only to lose it immediately as they try to use too much leverage to maximize returns.
The key to an appropriate money management strategy is committing only a small percentage of your trading capital (account risk percentage) to each trade. To understand how the percentage of your trading capital you commit in each trade can destroy your capital, let’s take a look at the table in the image below:
The first table shows what happens to the capital after 10 trades with a 50% win rate, 1:1 reward/risk ratio, and alternating wins and losses. You can see the capital depletes faster the higher the percentage risked per trade. Notice that after the 10 trades, the account is in a loss even though half of the trades were winners. The reason is that the reward/risk ratio is only 1:1, and each win is followed by a loss.
For the second table, there’s a streak of 10 losses. Notice that when risking only 1% of the capital in each trade, the account depleted by only 9.56% after 10 losses, but when risking 10% per trade, the account was depleted by 65.13%. Risking 50% per trade decimated the account by the 10th loss. So, you see how a trading account can be destroyed simply by committing a higher percentage of the account per trade.
Not understanding this math is one of the main reasons many traders blow up their trading account before their trading journey ever starts. Here’s the rule: the more capital you risk per trade, the quicker you will lose your entire capital, and once your capital is depleted, it takes a much larger gain to get back to the breakeven point. Here’s a table that shows how much gain required to bring an account to breakeven for different levels of equity loss:
|Amount of equity lost||Amount of gains necessary to return account’s equity to breakeven|
So, putting it all together, risking 1% of your capital per trade puts you down 10% after a streak of 10 losses, and you will need to gain 11% to break even. On the other risking 5% per trade puts you down 50% after a streak of 10 losses, and you will need to gain 100% to break even.
You should know that no matter how good you are, you must have a losing streak at some point. It’s better to commit a small percentage of your account capital in each trade so that when the losses come, your trading capital won’t be decimated. There’s no such thing as a perfect trading strategy that doesn’t lose. In fact, losses are part of the game; it’s your job to play in a way that protects your trading account when losing streaks come. Expert traders advise that you risk only 1-2% of your account in each trade so that losing streaks won’t knock you out of the game.
With this account risk percentage per trade, you can calculate the actual amount of risk per trade and use that to calculate the right position size that is suitable for your account size so that you don’t use too much leverage in your trading. The formula for calculating your position size is given as follows:
Position size = Amount to risk per trade (dollar value) / [stop loss size x unit value of the instrument]
- The stop loss size is in percentage (for stocks), number of ticks (for futures), or number of pips (for Forex)
- The unit value is the price per share (for stocks), the dollar value of a tick (futures), or pip value (Forex)
Note that the bigger your position size, the higher the leverage you’re trading with. Now, let’s take a look at other factors that make traders lose money in trading.
Poor risk management
Very close to money management is risk management because both deal with how to limit the risk of losing your trading capital. While money management and position sizing help you to avoid losing your account during a losing streak, risk management helps you to prevent a catastrophic loss that can decimate your account in one trade.
Basically, risk management deals with the use of a stop loss order to limit your loss in each trade to the amount you plan to risk in the trade. In every trade, you must place a stop loss order at a level you believe that if the price goes there, your trade setup becomes invalid and there will be no need to keep the trade. Paying lip service to stop loss (not using a physical stop loss order) is the primary cause of a catastrophic loss because it is difficult to manually close a losing trade.
Lack of a trading edge
No matter how well you manage your trading capital and how disciplined you are at using a stop loss, if your trading strategy doesn’t have an edge in the market, you will lose. The only thing is that you will bleed out gradually over a long time. Your strategy must have an edge to be able to survive the market and make you money.
A trading edge is a consistent anomaly you’ve identified in a market that can make you money if exploited with the right strategy. Most retail traders trade with strategies that have not been verified to have an edge in the market they are trading — there’s no way they won’t eventually lose!
Many new retail traders have unrealistic expectations of the market. They think that trading is a get-rich-quick scheme, so they expect to double their trading accounts in a few weeks or months. With this kind of expectation, they are liable to making money management mistakes by trading big position sizes and using huge leverage.
Apart from money management mistakes, unrealistic expectations can push traders to make trading errors, such as chasing after missed trades, jumping the guns, taking profits early, and not cutting losses short, all of which can lead to losses.
No trading plan
There is a saying that if you don’t plan, you plan to fail. This is very much true in trading. Your trading plan is like a compass you use to navigate the various market conditions; it tells you what to do in any market condition — whether to trade or not, which strategy to adopt in which market condition, how much to risk, how to exit with or without a profit, how to keep your trading journal, and when to review your trades.
Traders who don’t have trading plans will definitely lose!
Lack of trading education
At the root of all the factors we have discussed so far is a lack of trading education. Most retail traders jump into trading without taking time to learn how the market works and acquire the skills necessary to survive in the market.
It is not enough to learn trading basics or even learn how to perform fundamental and technical analysis. The major skill in trading is knowing how to research and develop a strategy with an edge, understanding the math of money management, developing the discipline to always use a stop loss, and having the mindset of a trader — thinking in probabilities!
If you want to be among the few traders who make money, you have to take time to learn the art of trading, develop a proven strategy with an edge, have the discipline to always use a stop loss, and change your mindset to think in probabilities — knowing that you will win some and lose some.