Determining Risk

There are many ways to go about determining how much of your capital you risk per trade. This is only one of them; this is how I do it. You do not have to do it this way.

If you trade, you need a trading plan, plain and simple. There are two main components to a trading plan. The first is a system. This consists of entry and exit rules - when to enter a trade and when to exit that trade. There are many other things that can be employed when developing a system, which can include determining optimal stops, targets, moves to breakeven, trailing stops, and a dozen other things. I will not cover them. Once you have your system defined, the next step is determining how much to risk on each trade. This is what I will cover.

I've seen too many threads on this forum where people just pick arbitrary risk values. Some people claim their system says to trade 10% per trade. Some say 20% per trade. I believe the beginners sticky thread says risk no more than 3%. So which one do you believe? None. You believe none of them. If you want something done right, you have to do it yourself. Determine your own risk per trade and you will be confidant that it's right, because it will be right. Guessing how many lots to trade is the same as guessing when to enter a trade. Read that sentence again if you need to.

The first thing you need is a sequence of trades. This comes after you develop your "system". How you get that sequence of trades is up to you. If you have a mechanical system, you may want to program it, in which case the program will be able to spit out a sequence of trades for you. I recommend TradeStation; it's features are very powerful. Another way to get a sequence of trades is to do it by hand. You've heard of manually scrolling back on charts to determine if you strategy is profitable, right? Well do the same thing and record each and every trade your system takes. Mainly what were looking for is pips profit and pips lost on a per trade basis.

So, for example, your system has a 50 pip limit (take profit) and a 40 pip stop loss, both of which spread is accounted for. Your sequence of trades could be the following:

50,50,-40,50,-40,50,-40,-40,50,50

This represents 10 trades. How many trades should you consider? Well, this is very controversial; many people use many different numbers. I think it depends on how often trade signals are generated. If you are trading off a 5 minute chart and get several signals a day, maybe a couple hundred trades. If you're trading off a daily chart and get a few signals a month, I would take around 100 trades. I wouldn't go any further back in time than a couple years, and I wouldn't use less than 100 trades. I know it's vague, but that's how trading is.

Once you have your sequence of trades you can determine the maximum drawdown of your system on a fixed lot basis. This is assuming you are trading one standard lot per trade, so a 50 pip trade would be equivalent to $500. The maximum drawdown is the maximum value your account can be "down" at any given time. For example if you start trading with $10,000 and at the worst time your account equity is $8,000, this is a 20% drawdown. If you account is $5,000, this represents a 50% drawdown. Maximum drawdown is also referred as "peak to valley" drawdown. This is the difference between the greatest peak and minimum valley on an equity curve. The following equity curve is from our trade sequence above and a starting account of $10,000:

http://i20.photobucket.com/albums/b2...nchell/ff1.jpg

The maximum drawdown is the difference between the peak ($11,200) and valley ($10,400). This is roughly a 7% drawdown.

Now, this is just so you understand what drawdown is on a fixed lot basis. This does nothing for determining your risk per trade. However, this is where you must choose how much drawdown you are willing to cope with. If you start with $10,000, are you going to have the ability to continue trading you plan if you account is drawndown to $8,000? Or will you give up and go home? Most people, me included, think a 25% drawdown is an acceptable risk. Some are willing to handle more, but most are willing to handle much less. I think this number is very representative of how confidant you are in your trading system. If it has been proven and you've been trading it live for some time, more risk equals more reward. I know one trader that has handled a 40% drawdown, and he's ok if another 40% drawdown comes. You're going to have to determine this on your own, but I would suggest 20% or less.

Now that you have a sequence of trades and know how much maximum drawdown you're willing to accept, you can determine how much of your capital to risk on a per trade basis. From here I would get a piece of software that does that calculations for you. I know, I know, right now you're thinking "so I gotta spend some money on software I'll use once". There is software out there than you can demo for more than you'll ever need it for. What this software does is spit out these optimal values so you dont have to play mathematician. Google "MSA" and you'll find what you need.

Back to our 10 hypothetical trades. How much can we risk per trade? Well, here is what our program tells us:

http://i20.photobucket.com/albums/b2...nchell/ff2.jpg

As you can see if you maximum drawdown tolerance is 20%, then it is optimal to risk 0.12 per trade, which is 12%. Here is our new equity curve with risking 12% per trade:

http://i20.photobucket.com/albums/b2...nchell/ff3.jpg

As you can see from the Y axis our account balance goes from $13,600 to $10,800. This is a 20% drawdown. This is very basic with only 10 trades.

Lets work with something more realistic. Here is a parameter study with a sample of 100 trades:

http://i20.photobucket.com/albums/b2...nchell/ff4.jpg

As you can see, if we take our 20% drawdown, we would be risking 6.93% per trade. Sure beats just guessing doesn't it?

This analysis is based on the exact sequence of trades as happened in time. Meaning the sequence of trades was not changed at all. For example, in 100 trades say we had 4 losses in a row and 20% drawdown from that. What if we had actually had 7 losses in a row? We would be pissing blood and wondering why we are in a 35% drawdown when our tests show a maximum of 20%. This is why I like Monte Carlo.

Monte Carlo analysis is a technique that randomizes your trade sequence 1000 times. So in your 100 trades, let's say you had 4 losses in a row. After you randomize that sequence of trades you could now have more than 4 losses in a row. Actually, you WILL have more than 4 losses in a row. This is an attempt to give a "worse case" scenario of your trade sequence. This is the same 100 trades with a Monte Carlo analysis:

http://i20.photobucket.com/albums/b2...nchell/ff5.jpg

As you can see once we randomize our trades, we get 4.01% as our risk per trade to stay under 20% drawdown. Before we were close to %7. So which one do you use? Well, once again, to be vague, that's up to you. Do you think your sequence of trades accurately reflects true market conditions that can be seen in future trades? Obviously you should risk no less than the analysis given by the current sequence of trades, but should risk no more than the analysis given by the randomized sequence of trades. What I do is pick a drawdown I would be "able" to cope with, but it would be difficult to deal with. This is my "worst case". I then set this value equal to my monte carlo result. In a nut shell what this is doing is matching my "worst case able to deal with" scenario with the "worst case scenario that can come out of those 100 trades".

For example my doomsday drawdown might be 25% and my realistic drawdown is 15%. I would run a monte carlo analysis of 25% and I would obtain a risk of 5%. So the worst case scenario with those 100 trades risking 5% per trade would be 25% drawdown. I would then use that 5% with the current sequence of trades and see what I got. In this case it was right at 15% drawdown. This tells me that I should "expect" a 15% drawdown, but should be able to "deal with" a 25% drawdown.

This has gotten to be much longer than I thought, so I will cut it off here. This is mainly for new traders, but I hope everyone can get something small out of it. This is how I have approached risk and drawdown and the affect they have on one another. This isn't how is has to be done.

sometimes i'm just amazed at how hardworking some people are on ff at creating detailed posts/pdfs/etc...Good job twinchell..very informative

Nice job twinchell! This should be required reading for all new traders. The fact is that position sizing can have a much greater impact on the returns of an account than the system used. Yet for every 500 threads on systems we get only one thread like this. Thanks for your contribuation!

Another great and informative post twinchell. Risk and Position sizing is one of those areas where, as you put it, "I still just pick arbitrary values". I read Fooled by Randomness, and it talked a lot about Monte Carlo Analysis.

I just have one question. Is your Monte Carlo program freely available, or does it cost money? I would love to have something like this to mess around with.

Thanks,
andersenws

Very nice post! It's good to see some solid information being posted. I vote sticky!

A sticky sounds good, but Merlin does not have stickies to the discussion forum, so it would have to be put else where and I think Twinchell wanted the thread to remain here in the discussion forum... It is a fantastic set of posts...

We'll just have to keep bumping it up where it belongs then won't we

Steve

Thanks for the feedback everyone. I really don't mind where the thread is located; put it where you think people will read it. I originally put it in the beginners forum but thought some people would shrug it off as crap if it were there. You know how some people think after they've been trading a couple weeks - "beginners forum, I'm past that crap".

To answer your question andersenws, the software has a 30 day demo period at no charge. I pay to use it because it has been so helpful to me. I won't post a link because I'm not trying to market the software or anything. I have no affiliation with it whatsoever, but Google "Market System Analyzer" and you'll see it. I'm sure there are other softwares out there that do the same thing. This is just the particular one that was recommended to me.

How about we leave this thread here for a while and then when momentum slows down we sticky it to the Beginner forum. It is really very useful and that would be good for instruction.

very well written, good stuff

best,
mike

Well, there is my lesson for today, thanks a lot twinchell.
Mateusz

Thanks so much, twinchell. I learn something today.

Two thumbs up!!

Definitely sticky material.

Thank you twinchell. Very informative!

As I predicted - I spend time typing all this up and nobody looks at it. A thread about a random spike in the market already has twice as many views in less than half the time. People just don't want to read about how to create a trading plan and become a successful trader; they want to know why the market moved 20 pips and what the new holy grail indicator of the week is. Im glad a half-a-dozen people got something out of it, but I guess you can say I won't be wasting my time doing any others. It's no shock whatsoever that only 5% of people are successful. I would be amazed if it was that high.

Hi twinchell,

It doesn't surprise me one bit either... the two most important things, determining risk and getting your mindset right tend to be the least exciting and therefore the most overlooked.

Please don't stop posting gems like this

Kind Regards
Steve

Hi Twinchell,
Do not be disheartened that your thread only got a few views.
Look at it this way.
Those that did read it got a lot out of it BUT...there are many traders on this forum who are probably not ready for something like this. They have not reached their journey in forex trading to realise that risk and money management is what will eventually be their 'Holy Grail'. When they do...they will read your thread with renewed interest and the light will click. Then the patience and consistency has to follow.
Personally I really enjoyed what you wrote , it certainly wins the 'thread of the week' award and thank you for pointing me in the direction of the MSA software.
Please do not stop posting. I would like to see this thread kept active or at least made into a sticky as the information you gave is invaluable.
Cheers
Antra

Yeah mate, good work. That was a good read. The effort put into it's obvious!

For the record, I never got around to reading this thread till now. Most of the time I'll be single-mindedly following a couple of threads for a while and be blind to any others that pop up. Every few days I'll explore around looking for anything else interesting.

I think you'll find that a lot of people will do the same. ....and then a lot just want a black box trading solution. LOL

,Bundy

twinchell, great posting, and thank you for contribution!

dont get upset. you mentioned the reason why less people read whats truely important - because they dont want to suceees, and as a result we have less than 5% survivors.

here is couple more good articles:

Money Management By Boris Schlossberg, Senior Currency Strategist, FXCM

cheers!