You know that trading involves risk, don’t you? You hear this a lot but what does it actually mean? Well, simply it means this: you can lose all your money!
Ever heard of the 90/90/90 rule? This states that 90% of retail traders lose 90% of their money in the first 90 days of trading. So unless you are happy to be one of those 90% then you better pay attention to your money and risk management!
In this unit we are going to look at risk management by reviewing the following topics:
- Probability game
- Stop Losses
- Win/Loss ratio
- Risk to reward
- Lot Sizing
- The effects of compounding
- Max losses / drawdown
The Probability Game:
A lot of people trade on intuition or feelings. In this course we have discussed many key elements of financial trading including trading psychology, technical and fundamental analysis and trading plan and strategy.
Throughout the course I have said several times that trading is a probability game. This is the truth that you need to understand. A successful trader is judged by one simple criteria – a positive P&L.
When I say it is a probability game, I am not saying it is like throwing dice or gambling. The aim is to stack as many elements as you can in your favour. This includes all the elements from the course: educating yourself, managing your psychology, trading the right markets and building a backtested strategy.
The first and most important part of any risk management strategy is to have taken all of these steps so that you are already ahead of the market, this will reduce your risk by more than any other factor.
Ever heard the saying: “Cut your losses and run your winners”? I think that is just another way of saying you have no stop losses or targets in the first place! When you start placing trades, your primary risk management tool is a stop loss.
Once a stop loss is set (and you commit not to move it), then you have set your maximum risk for that trade. A stop loss is also the basis of working out your targeted risk to return in your trading strategy.
The decision on where to set the stop loss is a combination of your strategy and the amount of risk you want to take. Some people say they always risk 1% or 2% but it is not as easy as that.
That is one way of setting risk but in reality, your stop loss may be at a technical level based on your strategy that does not equal that set % each time.
This is why backtesting is so important as you will be able to work out averages and ratios for your strategy that will allow you to adjust your risk via lot sizes rather than by moving your stop to an area that makes no sense for your strategy.
Ok so if our goal is always to move probability in our direction then the goal with risk management is the same. Some people will say that the most important thing is win/loss ratio, others risk to reward. For us, we will look to balance both in order to maximize our probability of being consistently profitable.
The first and most used ratio that you will see people talk about is the win/loss ratio. This is a very simple ratio, If you had 100 trades and 60 were winners and 40 were losers then your win to loss ratio is 1.5
It’s logical to say that if you have more winners than losers then you will be profitable. Unfortunately that is not true. In this example if your 60 winners made you $600 and your 40 losers lost you $800 then that is not useful.
However, whenever you are comparing strategies or backtesting results it is beneficial to have a higher win/loss ratio.
Risk to Reward Ratio
So how to take a win/loss to the next level? Well, the obvious next step is to work towards having a positive risk to reward ratio. This means that your winners earn you more money than your losers lose you.
There are two ways of looking at Risk to Reward; the first is the targeted Risk to Reward from your strategy and the second is actual risk to reward achieved. Let’s talk about both.
Targeted or Potential Risk to Reward (from strategy)
This is the R:R ratio that you are targeting in your trading plan. This is obviously an important goal. It makes sense to target a bigger win than your potential loss when placing trades as part of your strategy. But be careful – this needs to be realistic and based on actually achievable targets.
Let’s look at an example: On this chart you can see we are reviewing a strategy based on key levels (Round Levels). Here we have a stop loss set at 6300 and our Target is 6100. So here we have a realistic 1:2 risk to reward ratio, based on analysis.
Compare it to this chart, here I have set a target line of 1:5 risk to reward. Isn’t a higher R:R ratio better? Well, not if it is unrealistic. This target is sitting in clear air and there is no good technical or fundamental reason for price action to move here. It is just wishful thinking.
Actual Risk to Reward (Return)
For the purpose of measuring the actual risk to reward profile of your strategy you will need to backtest it. This is because expectation does not always meet reality. There may be missed orders due to slippage, moving spreads, targets that are just missed and then retrace to a loss and so on.
Having good backtested data will allow you to measure your true risk to reward ratio based on actual returns and losses.
So if we have 100 trades and from our backtested results we can see that our average loser is $100 and our average winner is $300 then we can say our actual R:R ratio is 1:3 with this strategy.
There are many ways to combine these rations but the simplest is to multiply your W/L ratio by your R:R ratio and if you get a number higher than 1 then you have a positive risk profile for your strategy.
But that is not quite the end yet. You can still blow up your account even with a positive W/L ratio and a positive R:R ratio. Now you have to look at lot sizing and averaging.
Lot sizing is the amount of contracts you buy each time you trade. By multiplying the stop by the number of lots and the $value per pip we will get a value for our risk in currency.
For example: our stop is 25 pips, we choose 2 lots and each pip is $10. Our risk in currency is $500. We then need to compare that to our trading account to understand how much we are risking as a percentage.
So if our trading account is $10,000 then the percentage risk of this trade is 5%. The simplest form of money management for your trading account is to choose a low risk percentage and adjust your lot size.
It is often recommended to keep your risk in the 1-4% range. So in this example if we wanted to risk 2% then we would do the calculation like this: Max risk = 2% of $10,000, so $200. To get the lot size we divide $200 by our stop and $ per pip. From the above this looks like this: $200/25/10 = 0.8 lots.
Fixed lots vs compounding
The important thing to remember about our ratios is that they are averages. This means that we have winners AND losers. A positive ratio is only saying that we will win on average.
A lot of people make the mistake of estimating their wins based on the average as if every trade is a winner. This is not the case, what happens in reality is that you will have a series of wins and losses that moves your account up and down. And this means that there is a possibility that you have the losses before the winners which can have a huge effect on your outcome.
This is really important to remember because people often put together projections where they compound returns after each trade based on a ‘fixed risk’ strategy, eg 2% of your account each time. This means that as your account grows your lot sizes will increase with each trade.
This is not recommended and I can show you an example why. The strategy below has a positive win/loss ratio and 1:1 risk to reward. So over time it should be positive. In this table you can see that this is the case:
Now look at the same strategy with the same trade outcomes and we are compounding after each trade:
As you can see this produces very different outcomes. This is why you should not be tempted to change your lot sizes and compound too soon. You should rather do it in steps. So grow your account to a target then increase your lots. You need to allow the law of averages to work otherwise your backtested results will fall apart.
Max Consecutive Losses (Drawdown)
A question many people have is why not increase your risk more if you have a positive combined ratio?
The answer to that question is that you can, up to a point. It is true that the higher your combined ratio the more you can safely risk in any one trade. The limiting factor is the risk of consecutive losses.
Let’s look at this example:
In this strategy we have more losses than wins but a good R:R ratio so our combined ratio is positive. We have 50 backtested trades and a positive balance using a fixed risk of 2%.
You might look at this and think it is worth increasing your risk much more but what happens when we have consecutive losses? In these results we had 14 consecutive losses but still made a profit in the end at 2% risk. However when increasing our risk to 8% we went bust after trade 14.
Well, what has happened is that we go bust! This is the perfect example of money management. We had a good strategy and combined ratio but pushed our risk too high and ended up losing everything.
This can even happen when both your W/L ratio and R:R ratio is positive.
This doesn’t mean that you should keep your risk to a minimum of 2%. In fact as retail traders with small accounts it may not even be worth the effort for that return.
If you have enough backtested data you can test higher lot sizes and increase it based on your max number of consecutive losses as can be seen here where we doubled our initial risk to improve our return and our max drawdown (14 consecutive losses) did not blow up our account.
So to summarize how we manage risk in trading:
I hope you have found this topic useful, I know it is a bit more complicated than just saying “Risk 2% max” but that is the truth about trading, you need to understand the full picture and not just expect easy answers.
This is also the end of our free Introduction to Financial Trading course. If you have completed all the units you will have a good understanding of all the fundamentals you need to know about trading.