Only trade positions with a 1:3 risk/reward ratio or better
Golden rules abound in this industry, and everyone seems to know the rules.
But who knows how to apply them?
How do you determine in advance if a trade will, in fact, deliver a 1:3 risk/reward ratio? At what point should you cut a loss short?
Unless you know how your strategy is performing, you can’t answer these questions. So may I suggest that instead of focusing on what you want your account to do, you should focus on what your account is doing?
Proper account analysis, performed on a trade-by-trade basis, has the power to reveal all. It will answer these questions:
What is the win/lose ratio for your strategy?
What is your risk/reward ratio?
What is your Longest Losing Streak (LLS)?
What is your Largest Losing Trade (LLT)?
The answers to these questions will put you in control.
I am assuming at this point that you have back-tested your strategy over at least the past 12-month period, and that you have historical account data for the back-test period. If not, guess what you’re doing next? Back-testing!
Win/Lose Ratio: Number of Winning Trades / Total Number of Trades x 100 calculates your win (Win%) percentage. 100 – Win% calculates your lose (Lose%) percentage. Win% / Lose% calculates the number of winning trades per losing trade, the win/lose ratio. A 2:1 win/lose ratio means 2 winning trades for each losing trade.
Risk/Reward Ratio: Total Profit on Winning Trades / Total Loss on Losing Trades calculates your risk/reward ratio. A 1:3 risk/reward ratio means you earned $3.00 for each $1.00 lost.
Longest Losing Streak (LLS): Largest Number of Losing Trades in a row over the historical trading period. Total value of these losing trades tells you the dollar amount of risk your trading capital must be able to absorb to survive.
Largest Losing Trade (LLT): Largest Losing Trade over the historical trading period. Like your LLS, the value of the LLT tells you the dollar amount of risk your trading must be able to absorb to survive.
I let my account performance tell me if I am doing it right, or doing it wrong. I use the results to tell me what to do next. It’s not complicated.
If I want to achieve a 1:3 risk/reward ratio, but I am getting only 1:2, then either my risk is too high, or my reward is too low. Either way, I need to review my strategy and amend it accordingly. If I am getting 1:3 or better I can do nothing, or I can consider lifting my risk a little to optimize future earnings performance.
If I want a 2:1 win/lose ratio, but I am getting only 1:1, then there is a problem with my entry/exit timing. I need to review my strategy and amend it accordingly. If I am getting 2:1 or better I can do nothing, or I can sharpen my entry/exit standards to optimize future earnings performance.
If I want to know how much capital I need to survive over a period of adverse trading conditions, I can use the combined value of the Longest Losing Streak (LLS) and the Largest Losing Trade (LLT) to give me a reasonably precise answer.
In 2014, starting with $10,000 capital and trading 1 x Standard Lot ($100,000 USD), the MYFXPT Trading Strategy made 65 trades. Of these there were 42 winners (64%), 21 losers (32%), and 2 breakeven trades(4%). This gives the strategy a 2:1 win/lose ratio, so on average, for every 3 trades we win on 2 and lose on 1, which is a reasonable batting average. More enlightening, however, is the dollar value of winning and losing trades. (view results)
Losing trades totaled $11,996, an average $571 loss per losing trade, or a 5.71% risk factor. Our 42 winning trades produced a profit of $104,965, or an average $2,499 profit per winning trade. Hence, the strategy generated a risk/reward ratio of 1:4.87, which is above average.
We could conclude from these results that our strategy offers excellent potential, but these results tell us nothing about long-term survivability.
The number one objective of risk management is to survive a period of adverse trading conditions. For example, whilst a 1:4.87 risk/reward ratio and a 2:1 win/lose ratio look good in theory, would the account have survived if it had suffered those 21 losing trades in a row, starting with the very first trade? The answer is a resounding NO. We started with $10,000 and lost $11,996...we're gone!
Knowing the Longest Losing Streak (LLS) of your strategy is critical to survival planning. In our case the LLS is 3 losing trades in a row between 20th August and 8th September 2014. Those 3 losing trades generated a $2,252 total loss, or an average $750 per losing trade. Hence, in our case $10,000 start capital is more than adequate to absorb the LLS without blowing the account. Drawdown was 22.52% over the historical trading period.
This is important. If our objective is to limit account drawdown to 50% of account funds, and our LLS is $2,252, then we need $4,504 minimum start capital ($4,504 x 50% = $2,252). If we don't have $4,504 in start capital, but we are comfortable accepting 75% drawdown, we can reduce start capital to $3,002 ($3,002 x 75% = $2,252). At the other end of the scale, if we want to be extra safe and accept no more than 20% drawdown, we will need to increase start capital to $11,260 ($11,260 x 20% = $2,252). So knowing the LLS puts you in control of managing capital needed to survive adverse conditions ahead of time.
There is one final piece of information that is critical to survival, and that is the Largest Losing Trade (LLT) that occurred over the historical trading period. In our case we had a $2,310 LLT on 18th February 2014, and of course, we can employ the same drawdown analysis to ensure account survival, but the question remains: what would have happened if we experienced this LLT within the LLS, or worse still, what if we had 3 of these LLT's in a row? Suddenly we are faced with the potential for a combined losing streak of $6,930 in total, or 69.3% drawdown.
What is the statistical probability?
We completed 65 trades over the historical trading period, incurring an LLS of $2,252 and an LLT of $2,310, so there is currently a 1 in 65 chance of this occurring again. That is, over the next 65 trades there is the chance of an approximate $2,300 loss occurring either from an LLS or LLT. If these were to occur together, our risk is $4,562 over the next 65 trades.
If we combine the two, and use this as the basis of our analysis, the probable risk is that the account would need to withstand a potential loss of $4,562 over 65 trades.
If we want to limit drawdown to 50% we need $9,124 start capital ($9,124 x 50% = $4,562). If we accept 75% drawdown we need $6,082 start capital ($6,082 x 75% = $4,562), but if we want to limit drawdown to 20% we need $22,810 start capital ($22,810 x 20% = $4,562). What if you don't have $22,810 capital? You can always reduce your lot size from Standard Lots ($100,000 USD contract) to Mini Lots ($10,000 USD contract), in which case $2,281 capital would be required, or trade in Micro Lots ($1,000 USD contract) with $228 capital. See how all this account analysis stuff puts you in control?
All you have to remember is this:
Account analysis is dynamic, and the results will change with each closed trade. It is important, then, that you conduct regular account analysis to keep your trading performance data up to date. The risk factor, win/lose ratio, risk/reward ratio, LLS, and LLT, can all change with each completed trade, so it is in your best interests to update data accordingly.
As you can appreciate, this brief outline is far from being a complete study of risk management. My purpose here is only to highlight to you the work that needs to be done behind the scenes to ensure that funds are kept as safe as possible, whilst maximising potential returns. This is a risky business we are in, and we will only ever have statistical probabilities to work with. Attention to detail and routine account analysis will ensure that the odds are always stacked in your favour.
Thanks for the feedback, and thanks for your point of view. Sometimes the explanation is more complex than the subject, and risk management is one such subject. But in the end it all comes back to 4 pieces of information - win/lose ratio, risk/reward ratio, LLS, and LLT. This information is easy to come by through simple analysis of account performance...true? With this information in hand we can instantly determine if we are meeting our account objectives or not, and if not, what to do next.
My point here is to emphasize that risk management is less about following rules, and more about understanding what is actually happening with account performance. If, for example, we want our account to meet the 1:3 risk/reward ratio, and we are actually getting better than this, then we are meeting and going beyond our objective. If we are not meeting our objective then we have to do something...reduce risk or improve reward. It is this definite choice of action that makes risk management easy, just like a set of traffic lights where we go if green, stop if red, and do nothing if amber. That's management! 😎
HIGH RISK WARNING: Foreign exchange trading carries a high level of risk that may not be suitable for all investors.
Leverage creates additional risk and loss exposure. Before you decide to trade foreign exchange, carefully consider your investment objectives, experience level, and risk tolerance.
You could lose some or all of your initial investment. Do not invest money that you cannot afford to lose. Educate yourself on the risks associated with foreign exchange trading, and seek advice from an independent financial or tax advisor if you have any questions.
Any data and information is provided 'as is' solely for informational purposes, and is not intended for trading purposes or advice.
Past performance is not indicative of future results.