The simple guide to risk management
What Do I Really Need To Achieve To Be Profitable?
I'm going to keep this example very simple and in my own experience simple works a lot better than complicated scale methods. To break even in trading you have to be right around 40% of the time if your losers are cut at -1R (1xRisk) and your winners are sold at +2R (2xRisk). You would actually make a small profit.
I'm going to keep this example very simple and in my own experience simple works a lot better than complicated scale methods. To break even in trading you have to be right around 40% of the time if your losers are cut at -1R (1xRisk) and your winners are sold at +2R (2xRisk). You would actually make a small profit.
Here is an example of ten trades.
Account Size = £100,000
Risk per trade = 1% max (£1000)
6 Losers = -£6000
4 Winners = £8000
Trading Costs = -£350
Total = £1650 Profit or 1.65R
We hear it all the time, let your winners run and cut your losers. Now in the example above we did cut the losers, but we also cut the winners at +2R. If we had one trade that made 7 or 8R out of the four winners and a couple of the 2R winners stopped out at +1R because we were shooting for bigger winners we would have a profit of 6.65R or better.
If you can be right around 50% of the time things get even better.
5 Losers = -£5000
5 Winners = £10000
Trading Costs = -£350
Total = £4650 Profit or 4.65R
This example is still limiting the winners to +2R
When times are tough your account could churn as the examples below show.
Example 1,
5 Losers = -£5000
2 Winners = £4000
2 Stopped at 1R Profit = £2000
1 Stopped at break even = £0
Trading Costs = -£350
Total = £650 Profit or 0.65R
Example 2,
7 Losers = -£7000
2 Winners = £4000
1 Stopped at 1R Profit = £1000
Trading Costs = -£350
Total = -£2350 -2.35R
To make money you need to risk 1 to make 2 or more and be right around half of the time. If you can average 1R on all your trades you are doing very well. This includes all your losers and scratch trades. If you cannot be right around 45% of the time and you cannot let your winners run you will at best have an account that churns and it's likely you could be part of the 90% of people who give money to the market.
If you cannot achieve a win rate of around 50% in good market conditions then your entry criteria could be flawed. If you have a win rate of around 40% but struggle to hit 3R+ with your winners then your entry criteria or maybe your trailing method could be flawed. there are so many combinations but it all comes down to cut your losers and let your winners run.
The Holy Grail Indicator
What I have just tried to explain is the first thing you will learn in any trading book.
Most people will read this and then move straight into "The Search for the Holy Grail Indicator". When this doesn't work then they will go on the next quest. "The Search for the Holy Grail Combination of Indicators". Most people have blown up by now and have moved on to something new. The few who understood the risk management and only risked 0.5% or 1% max of their account per trade are still hanging in there. I believe that the very basics of trend, money management and a setup that will give you an achievable reward on the time frame you choose to trade is as good as you can ask for and a very good starting point to work on an edge.
The market does not move because an indicator is oversold or a death cross is triggered. If it did the 90% of people who use them would be consistent winners and not consistent losers.
The math and the math alone is the only thing that will keep you in the markets long enough for the big winner to come along, risking 1 to make 2 or more and being right around half of the time. Now how hard can it be?
The thing is it's like dieting or fitness training. Everyone is an expert but 9 out of ten people cannot see it through long enough to see the results.
Scaling Out Eliminates Big Winners
6 Losers = -£6000
4 Winners = £8000
Trading Costs = -£350
Total = £1650 Profit or 1.65R
Scale 1/2 at +1R
6 Losers = -£6000
4 Winners = £6000 (2R from entry now pays 1.5R)
Trading Costs = -£400 (Four additional sell costs)
Total = -£400 (You now have a negative expectancy)
If you can be right around 50% of the time
5 Losers = -£5000
5 Winners = £10000
Trading Costs = -£350
Total = £4650 Profit or 4.65R
Scale 1/2 at +1R
5 Losers = -£5000
5 Winners = £7500 (2R from entry now pays 1.5R)
Trading Costs = -£412.5 (Five additional sell costs)
Total = £2087.5 Profit or 2.08R
In this example scaling out has more than halved your profit.
When times are tough your account could churn as the examples below show.
5 Losers = -£5000
2 Winners = £4000
3 Stopped at break even = £0
Trading Costs = -£350
Total = -£1350 Profit or -1.35R
Scale 1/2 at +1R
5 Losers = -£5000
2 Winners = £3000
3 Stopped at b/e = £1500 (1R hit for stop trail)
Trading Costs = -£412.5
Total = -£912.5 Profit or -0.9R (0.4R better)
This example actually helped you out but by a very small amount. Is it worth saving 0.4R on this bad spell to lose out on 2.5R when you're right 50% of the time? I think not. The above example has a very low expectancy even when times are very good.
Example 2
7 Losers = - £7000
3 Winners = £6000
Trading Costs = -£350
Total = -£1350 Profit or -1.35R
Scale 1/2 at +1R
7 Losers = - £7000
3 Winners = £4500
Trading Costs = -£387.5
Total = -£2887.5 Profit or -2.9R
A run of seven losers and only 3 winners happens in trading. The simple risk 1 to make 2 outperforms the scale method by a huge amount in this example and you were right just 30% of the time. You actually lost less than half the amount of the scale method.
People like to teach scaling out to give new traders the feel good factor. Locking in gains. The truth is scaling out before 2R destroys your expectancy. Scaling out above 2R has its merits but you will never get that huge winner. To consistently hit 2R trades you need a trade setup that realistically gives you 1 to 4 risk to reward or better on entry. The big money is made by adding to winning trades. One big trade will more than make up for a bad market period or a bad year.
The examples above are not going to blow your mind, this is the no BS reality of what you have to achieve just to keep afloat and before you can learn to swim. The bar really isn't set that high. You can be wrong more than right and still get into the top 10% of traders.
Jase @stealthsurf
Account Size = £100,000
Risk per trade = 1% max (£1000)
6 Losers = -£6000
4 Winners = £8000
Trading Costs = -£350
Total = £1650 Profit or 1.65R
We hear it all the time, let your winners run and cut your losers. Now in the example above we did cut the losers, but we also cut the winners at +2R. If we had one trade that made 7 or 8R out of the four winners and a couple of the 2R winners stopped out at +1R because we were shooting for bigger winners we would have a profit of 6.65R or better.
If you can be right around 50% of the time things get even better.
5 Losers = -£5000
5 Winners = £10000
Trading Costs = -£350
Total = £4650 Profit or 4.65R
This example is still limiting the winners to +2R
When times are tough your account could churn as the examples below show.
Example 1,
5 Losers = -£5000
2 Winners = £4000
2 Stopped at 1R Profit = £2000
1 Stopped at break even = £0
Trading Costs = -£350
Total = £650 Profit or 0.65R
Example 2,
7 Losers = -£7000
2 Winners = £4000
1 Stopped at 1R Profit = £1000
Trading Costs = -£350
Total = -£2350 -2.35R
To make money you need to risk 1 to make 2 or more and be right around half of the time. If you can average 1R on all your trades you are doing very well. This includes all your losers and scratch trades. If you cannot be right around 45% of the time and you cannot let your winners run you will at best have an account that churns and it's likely you could be part of the 90% of people who give money to the market.
If you cannot achieve a win rate of around 50% in good market conditions then your entry criteria could be flawed. If you have a win rate of around 40% but struggle to hit 3R+ with your winners then your entry criteria or maybe your trailing method could be flawed. there are so many combinations but it all comes down to cut your losers and let your winners run.
The Holy Grail Indicator
What I have just tried to explain is the first thing you will learn in any trading book.
Most people will read this and then move straight into "The Search for the Holy Grail Indicator". When this doesn't work then they will go on the next quest. "The Search for the Holy Grail Combination of Indicators". Most people have blown up by now and have moved on to something new. The few who understood the risk management and only risked 0.5% or 1% max of their account per trade are still hanging in there. I believe that the very basics of trend, money management and a setup that will give you an achievable reward on the time frame you choose to trade is as good as you can ask for and a very good starting point to work on an edge.
The market does not move because an indicator is oversold or a death cross is triggered. If it did the 90% of people who use them would be consistent winners and not consistent losers.
The math and the math alone is the only thing that will keep you in the markets long enough for the big winner to come along, risking 1 to make 2 or more and being right around half of the time. Now how hard can it be?
The thing is it's like dieting or fitness training. Everyone is an expert but 9 out of ten people cannot see it through long enough to see the results.
Scaling Out Eliminates Big Winners
6 Losers = -£6000
4 Winners = £8000
Trading Costs = -£350
Total = £1650 Profit or 1.65R
Scale 1/2 at +1R
6 Losers = -£6000
4 Winners = £6000 (2R from entry now pays 1.5R)
Trading Costs = -£400 (Four additional sell costs)
Total = -£400 (You now have a negative expectancy)
If you can be right around 50% of the time
5 Losers = -£5000
5 Winners = £10000
Trading Costs = -£350
Total = £4650 Profit or 4.65R
Scale 1/2 at +1R
5 Losers = -£5000
5 Winners = £7500 (2R from entry now pays 1.5R)
Trading Costs = -£412.5 (Five additional sell costs)
Total = £2087.5 Profit or 2.08R
In this example scaling out has more than halved your profit.
When times are tough your account could churn as the examples below show.
5 Losers = -£5000
2 Winners = £4000
3 Stopped at break even = £0
Trading Costs = -£350
Total = -£1350 Profit or -1.35R
Scale 1/2 at +1R
5 Losers = -£5000
2 Winners = £3000
3 Stopped at b/e = £1500 (1R hit for stop trail)
Trading Costs = -£412.5
Total = -£912.5 Profit or -0.9R (0.4R better)
This example actually helped you out but by a very small amount. Is it worth saving 0.4R on this bad spell to lose out on 2.5R when you're right 50% of the time? I think not. The above example has a very low expectancy even when times are very good.
Example 2
7 Losers = - £7000
3 Winners = £6000
Trading Costs = -£350
Total = -£1350 Profit or -1.35R
Scale 1/2 at +1R
7 Losers = - £7000
3 Winners = £4500
Trading Costs = -£387.5
Total = -£2887.5 Profit or -2.9R
A run of seven losers and only 3 winners happens in trading. The simple risk 1 to make 2 outperforms the scale method by a huge amount in this example and you were right just 30% of the time. You actually lost less than half the amount of the scale method.
People like to teach scaling out to give new traders the feel good factor. Locking in gains. The truth is scaling out before 2R destroys your expectancy. Scaling out above 2R has its merits but you will never get that huge winner. To consistently hit 2R trades you need a trade setup that realistically gives you 1 to 4 risk to reward or better on entry. The big money is made by adding to winning trades. One big trade will more than make up for a bad market period or a bad year.
The examples above are not going to blow your mind, this is the no BS reality of what you have to achieve just to keep afloat and before you can learn to swim. The bar really isn't set that high. You can be wrong more than right and still get into the top 10% of traders.
Jase @stealthsurf