Why bother? What’s the problem?
It often seems that retail traders do not understand, let alone effectively apply, the concepts of risk/money management in their trading. By this I mean that they would struggle to answer the following questions:
- How much money should I risk on any one trade?
- How much money should I risk on trades that are open at the same time?
- What is the “statistical edge” (whether positive or negative) of my strategy?
- What is the volatility/variation of results for my strategy?
- How should the answers to (3) and (4) impact on my answer for (1)?
- What is the expectancy of my strategy?
- Why are transaction costs important?
- What are realistic return targets from my trading, over a month, over a year?
The reason why I am confident that most retail traders are unlikely to know that is because I am coming across more and more professional traders (working in banks and hedge funds) that don’t know the answers to these questions either.
I am not going to be providing my view on the answers to all these questions in this blog post. Instead I will provide some data on all the K5 January trades I took in January. This data should provide some food for thought for answering the questions above. Happy reading!
Example of risk management in action
Throughout January I have gradually increased the amount of money risked per trade, gradually making the way to £200/trade, as shown on the following graph:
This £200 is divided by the stop loss size (in pips/points) to determine the volume/quantity I should use for the trade. Thus, the stop loss size varies for each trade, the quantity traded varies for each trade, but the financial risk per trade is always about the same. For this past week the risk per trade has been about £175. Next week this will increase to around £200. How much should this figure be for any trader?
So how much should you bet on each trade?
Well, that depends on:
1. The size of your trading capital – do you have £10k, £500k or £5 million in your trading account/capital.
2. Your attitude in terms of risk-seeking/risk-avoidance, and general aggressiveness (which will in turn depend on whether you have another source of income, dependents, your age, etc)
3. The amount of edge of your trading style (for me the past month it has been 4.2%, see table below).
4. The volatility in the results of your trading style. Assuming that the edge across two strategies is the same, then if you have a low win rate but win really big when you win, then you should use less per trade. If you have a high win rate but less win per trade then you should bet more.
My suggestion would be to bet as small as possible until one is confident that they are trading with an edge. The purpose of that is to protect your trading capital until the point in time that you are consistently trading well, meaning that you have a positive expectancy every time you put on a trade. This is what I have been doing for two and a half years – my position size has varied between £50 to £250/trade, which is a very small portion (way less than 1%) of my available trading capital. Equally important, once you start trading well, you need to increase your position sizing – this is another common point that retail traders, as well as traders in hedge funds (or other trading entities) struggle with.
So, in a nutshell, a lot of this is dependent on the edge of a strategy as well as the volatility in the results.
Hints for calculating “edge” – using my trading statistics for January 2016
Here are two more sets of statistics that may help you think about these things – the first is an overview of how effective the 88 valid & executed setups have been for me in the month of January – did the valid setup correctly predict price movement (yes/no/sort of):
The second looks at the actual hard profit+loss for the month, broken down by financial instrument:
Explanation of the above chart: The second column (from the left) indicates the number of K5 trades taken in the instrument. The next column shows the total amount of R (where 1R = £200) risked for all those trades. Bearing in mind that the R risked per trade has gradually increased (see the post on risk/money management for more details on that). Then you have the amount of profit (or loss) expressed in R, and then the the amount of profit/loss in £ (which is the prior column multiplied by £200). Finally, and i guess the most important column is the return expressed as a proportion of the amount risked. I’d like to propose that this is an approximation of the strategy’s edge.
I did an equivalent calculation for the 68 trades I did in December (see bottom of that blog post).
Most people would laugh at an edge of 4.2% – that is most non-professional people. Any serious professional in the trading industry would sell their mother in exchange for a 4.2% edge. No, I don’t expect anyone reading this to agree with me on that point.