“Speculate with less than 10% of your liquid net worth. Risk less than 1% of your speculative account on a trade. This tends to keep the fluctuations in the trading account small, relative to net worth. This is essential as large fluctuations can engage {emotions} and lead to feeling-justifying drama.” – Ed Seykota

This was an interesting Ed Seykota quote, it is a rare instant where a Market Wizard quantifies risk management with numbers not just a metaphor or a universal principle Let’s break down this quote for what it means. 

First you have to consider your net worth in cash equivalents. If you are a millionaire based on your stock holdings, retirement funds, bonds, savings, and other cash equivalents then you have a $1,000,000 in these accounts. So your active trading account should be $100,000 according to Mr. Seykota. If your liquid net worth is $100,000 then your active trading account would be $10,000. Now the key is to remember is that he is not saying you can’t have long term investments, or other types of accounts just that your speculative trading capital should be only 10% of your liquid net worth. One reason hw says this is that you have to be able to trade without putting your lifestyle at risk. This removes a lot of the emotions, ego, and stress where if you blow up your trading account you still have 90% of your net worth intact. The quote is probably targeted at high net worth individuals but you can grow a small account into a big one with consistent returns and compounding capital, you can also add to your trading account from other sources of income.

Then his second line of defense is the 1% total capital at risk per trade for your trading account. This is very commonly misunderstood by the majority of people. This does not refer to position size, it refers to the potential of loss. If you have a $100,000 trading account and you have a position size of $10,000 in a trade your trading vehicle would have to drop 10% for you to be down 1% on your trading account. A 10% drop on a position that is a $10,000 position size is $1,000. $1,000 is 1% of a $100,000 trading account. The volatility of the trading vehicle and the placement of the stop loss for the position size defines your risk. (“I intend to risk below 5 percent on a trade, allowing for poor executions.” – Ed Seykota)

While these position sizing parameters and the risk management will virtually remove the risk of financial ruin from your trading that is not really his primary reason for these stringent guidelines. The real problem he is solving is the risk of emotional ruin through the engagement of feelings. Big losses can quickly cause a trader to lose control of their feelings, over ride their trading plan, and self destruct. This is why Ed Seykota focuses primarily on the management of emotions in his writings and his website.

To be a successful long term trader you must first get your risk management and psychology right before you even begin to develop a trading system. This quote does that by setting the right parameters for position sizing from the start.