I was rereading a great book the other day Against the Gods by Peter Bernstein. It is in the top 5 books traders MUST read. When you start to look for your next trade pretty much any chance of success you have is related to the great minds detailed in this book.
While numbers have existed nearly as long as man it is relatively recently that our species has used them to determine probability. A very direct line can be spotted from the moment humans started using math to predict outcomes to the massive acceleration in technical advances.
As I read the book (for the fourth time) one thing hit me a bit different. I had read it before but for some reason it stuck this time.
Arguably, the most successful risk managers are insurance companies. They have been around for thousands of years and have successfully (in a vast majority of the cases) been successful at predicting outcomes. But the success is not only in their ability to predict, it really lies in another aspect of risk management.
Position sizing is a fundamental aspect of risk management and can be the single most effective way to ensure trading success.
Insurances companies are able to be successful because while they calculate the probability of a natural disaster happening, they also calculate the odds of multiple disasters happening in s short period of time. They hold reserves back to make sure they can survive if the worst, even worse than they expected, happens.
This concept applies to trading. It is tempting to jump into a trade you are excited about with both feet and way too much of your capital. But since we will be wrong when we trade in some percentage if that big exciting trade is the one we are wrong on, it could wipe us out. If, however, we use a portion of our capital that reserves enough to weather that trade, and possibly the next few, being wrong, we can be in another trade that could make us more than all of our losses.
Calculating probability in trades is key to success and no one explains it better than Don Fishback. His Quick Start Guide To Options Success is the perfect place to start or refresh your strategy. Grab your free copy here.
Keep learning and trade wisely,