Market Guides

# Simple guide to risk management

08 Oct 2014 | by: Richard Mason

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)

I like to include my trading costs in my risk but to keep things simple I’ve added them to the totals.

6 Losers = -£6000

4 Winners = £8000

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

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.

5 Losers = -£5000

2 Winners = £4000

2 Stopped at 1R = £2000

1 Stopped at break even = £0

Total = £150 Profit or 0.15R

7 Losers = -£7000

2 Winners = £4000

1 Stopped at 1R = £1000

Total = -£2350

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 will most likely 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 is flawed. If you have a win rate of around 40% but struggle to hit 3R+ with your winners then your entry criteria is flawed. there are so many combinations but it all comes down to cut your losers and let your winners run. The math doesn’t lie.

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 would argue that the very basics of trend, money management and a setup that will give you an achievable 2R on the timeframe your using is as good as you can ask for. I’m not going to go into fundamentals at this point. I will say that the best risk reward on a weekly uptrend is usually when its doom and gloom on a daily pullback. In the first tutorial I bought GKP when it was falling out of the sky on the daily but my trade was on a monthly chart. I was stalking that day to get the right reward to risk.

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?

I know i had it nailed down before I went to primary school. 1+1=2, 1-1=0…

The thing is its like dieting or fitness training, everyone is an expert but 9 out of 10 people cannot see it through long enough to see the results. I put a bit of weight on last year after a few knee operations and being stuck in front of the PC, every overweight person I know told me how to lose weight.

Scaling Out Eliminates Big Winners

6 Losers = -£6000

4 Winners = £8000

Total = £1650 Profit or 1.65R

Scale 1/2 at +1R

6 Losers = -£6000

4 Winners = £6000 (2R from entry now pays 1.5R)

Total = -£400 (You now have a negative expectancy)

If you can be right around 50% of the time

5 Losers = -£5000

5 Winners = £10000

Total = £4650 Profit or 4.65R

Scale 1/2 at +1R

5 Losers = -£5000

5 Winners = £7500 (2R from entry now pays 1.5R)

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

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)

Total = -£912.5 Profit or -0.9R (0.4R better)

This example actually helped you out but by a very small amount but is it worth saving 0.4R on this bad spell to lose out on 2.5R when your right 50% of the time. I think not. The above example has a very low expectancy even when times are very good.

7 Losers = -£7000

3 Winners = £6000

Total = -£1350 Profit or -1.35R

Scale 1/2 at +1R

7 Losers = -£7000

3 Winners = £4500

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 3 reward to risk 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 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.

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This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

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