Presented by Jeff Bryant, HomeTrader.
Hello - and welcome to Episode 6 in our ongoing series on Successful TradingThis episode looks at Risk Management and then what I refer to as the Arithmetic of Trading. Well start with Risk Management. This is simply THE most important part of the business. You may have heard that before; you may have READ it before. Theres a reason for that its true! You can fiddle around endlessly with ALL the other components of your trading plan, but it all amounts to nothing if you dont get your risk management right.
Now We KNOW were going to get losing trades. Not only will we get losers, well get groups of them. When we do, the value of our portfolio drops - we call this Drawdown. The primary objective of trading is to manage the impact of such a group of trades and by so doing, manage the associated Drawdown.
The beauty of a good Trading Plan is that YOU decide how much Drawdown youre prepared to accept unlike the average Investor, who is at the whim of the market. There are 2 primary components involved in doing this. Firstly, we can limit the amount we lose in any one trade. Secondly, we limit our exposure to any one stock.
When we first take a trade, we set an initial or fixed stop loss, which acts like a safety net. If the price falls to this level, we will simply close the trade and move on. In so doing, were in charge we decide the outcome!
Heres an example of this in action. In this example, entry on June 1 at $5.40. The Fixed Stop Loss is set at $4.52. If the price drops to this level well get out. The first thing to note is that we havent set the exit point too close to the action. You have to give a stock room to breathe. This is called the Stop Size, letting us control how much we lose we manage the risk in the trade.
In this case, the stop loss is set at a size of $0.88 cents. So if, for example, we buy 227 shares we limit our loss should the trade go against us to just $199.97 (in this example). Now of course, we dont always get out where we would like shares do gap occasionally. However, not all trades go completely against us. Some head up first, before falling back. These wont cost us everything we were prepared to risk - And from our back testing, we can see the average of our losers and ensure that this is less than our maximum loss.
But what happens when the price drops (or gaps) 50% overnight? Well, firstly, the occurrence of such an event, particularly if you follow the methodology we teach at HomeTrader is very rare indeed. In fact, we have to look back as far as 1999 in this instance, it was Biota. It closed at $9.10, opened the next day at $5.00, then dropped to $3.00, before recovering to close at $4.35. This is why we dont put all our eggs in the one basket.
To contain the damage from an event like this, its essential that we dont have too much exposure in any one place. We do this by limiting our position size. Lets say youre a trader with a total capital of $10,000. By having a limit of 20% in any one trade means you have a maximum exposure of $2,000. Even in a worst-case, we survive to take the next trade.
Lets have a further look at the benefits of containing our losses. I call this the Arithmetic of Trading. Lets imagine we have that same fund of $10,000. Lets also assume that well limit our loss in any single trade to 2% of that fund or $200. For the sake of the exercise, well assume that our universe of trades is 40% winners, 60% losers.
So out of every ten trades, wed expect 4 winners & 6 losers. Despite knowing that some of our losers will have gone up first, were going to assume that all of our losers cost the whole amount. On the other side of the equation, well work on an average win of $600 an average win to an average loss ratio of 3 to 1. The reason for this is that we let our profits run.
Well look at this in more detail next time, but for now, Im using my benchmark of 3 to 1 in a base-level medium-term system, trading just the long side of the market, without any leverage. This ratio will vary with different trading styles, but should give you the idea. On the right hand side, the 6 losers cost us $1200. On the left, the 4 winners make us $2400. The difference is a profit of $1200.
This exercise raises a number of points.
1) Firstly, it shows the benefits of taking a small loss and letting profits run, rather than jumping out too early.
2) Secondly it shows that we can be profitable with a win rate at just 40%. In other words, its not just about picking winners you dont have to be right ALL the time!
3) Thirdly it shows that trading, done properly, creates a Positive Expectancy Environment.
So through the process of controlling losses and allowing winners to run, we can alter the trading equation in our favour. This makes the difference between success and failure.
Next time, well look at how to lock in profit.
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#04: Entry Conditionsby tradingshares1,294 views
great video mate!
simoncolemansongs 2 years ago