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Rationale behind "Risk Per Trade" and "Risk/Reward Ratio"?

  • Post #1
  • Quote
  • First Post: Sep 21, 2010 7:40am Sep 21, 2010 7:40am
I regularly read that we should set our Risk Per Trade at "2%" and only look for trades with a R:R of "2:1".

Why? Who set these figures? How do we determine if these figures are appropriate for our own trading style or risk appetite?

I understand the logic of the two concepts but I am looking for the maths/methodology behind the choice of figures.
The higher the R:R the lower the win/loss probability and vice versa.
You can also choose a different percentage of equity to risk
Which set of parameters suit your method?
The only answer is backtest
Quoting dmuk
Why? Who set these figures?
'

Chuck came up with these figures.

Good for you for questioning conventional wisdom.

I have a question for you. When questioning conventional wisdom, do you think you're going to get a satisfactory answer from the conventional?
  •  Czech
  • | Joined Feb 2010 | Status: You Don't Know What You Don't Know | 111 Posts
The 2% number has to do with what i believe is referred to as the "risk of ruin". It assumes you recalculate what 2% is after every trade. The point is that using 2-3% risk per trade allows you exponentially more losing trades before a margin call will occur compared to trading with 5+%.

The actual numbers are around here somewhere and if you were so inclined you could easily build the table yourself in excel. You could also read up on how compound interest works for a better understanding.
Quoting Czech
The 2% number has to do with what i believe is referred to as the "risk of ruin". It assumes you recalculate what 2% is after every trade. The point is that using 2-3% risk per trade allows you exponentially more losing trades before a margin call will occur compared to trading with 5+%.

The actual numbers are around here somewhere and if you were so inclined you could easily build the table yourself in excel. You could also read up on how compound interest works for a better understanding.
Actually all it boils down to is the optimal fixed fraction to trade(known as optimal f by Ralph Vince). For example if you optimal f is 20%, trading 2-3% means you are to the left of the optimal f, you get lesser geometric growth with reinvestment but your drawdown will be less. If you trade the optimal fraction of 20%, you maximise your return but your drawdown could be 20% or even more. The worse is if you trade to the right of the optimal f, you get a higher drawdown but lesser return compared to the optimal f fraction
Quoting ash234
Actually all it boils down to is the optimal fixed fraction to trade(known as optimal f by Ralph Vince). For example if you optimal f is 20%, trading 2-3% means you are to the left of the optimal f, you get lesser geometric growth with reinvestment but your drawdown will be less. If you trade the optimal fraction of 20%, you maximise your return but your drawdown could be 20% or even more. The worse is if you trade to the right of the optimal f, you get a higher drawdown but lesser return compared to the optimal f fraction
Thank you - interesting stuff.

Ralph Vince is next on my reading list.
  • Post #7
  • Quote
  • Edited at 9:06pm Sep 22, 2010 8:41pm | Edited at 9:06pm
  •  Czech
  • | Joined Feb 2010 | Status: You Don't Know What You Don't Know | 111 Posts
Quoting ash234
Actually all it boils down to is the ...
You boiled down a simple principal into theoretical money management. Optimal f assumes your outcome probability and distribution are known. As a result, in trading, it's theoretically perfect but practically useless. While you may have an overall probability to win 60% of the time, a given trade may only ever have a 5% chance of winning due to factors outside of your analysis.
Create a vision and never let the environment, other people's beliefs, or the limits of what has been done in the past shape your decisions. In another words ignore conventional wisdom and create your own. Acquire information with a critical mind and be ready to discard what does not make sense, even if you do not know enough to do so correctly.
The ideas behind all of this principles are all sound and good, but many times you will find that your particular approach, requires you to do something different. For instance, one of the systems that I use is heavily based on fundamentals. Therefore i do not have a predefined stop loss - I exit when the fundamentals change and tell me to. This makes it impossible for me to determine a certain % to risk so instead I use my leverage to gauge my risk. Depending on a certain pair's volatility i will start from a 1:0.1 to 1:0.25 leverage and then scale into my positions. I scale in because sometimes the fundamentals take some time to impact the market, and more often then not I get to add at a better price. The R:R is also unknown, because it is hard for me to determine how long the fundamentals will stay a certain way. All of this is different for my "more technical" systems. As you can see from what I said above, there is more than one way to skin this forex cat, so it does not matter who came up with the whole 2% thing, or why. The only important thing is if it makes sense for your approach in the long run. HTH
Stubbornly persistent
  • Post #9
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  • Last Post: Sep 23, 2010 12:12am Sep 23, 2010 12:12am
Quoting sergiu
Create a vision and never let the environment, other people's beliefs, or the limits of what has been done in the past shape your decisions. In another words ignore conventional wisdom and create your own. Acquire information with a critical mind and be ready to discard what does not make sense, even if you do not know enough to do so correctly.
The ideas behind all of this principles are all sound and good, but many times you will find that your particular approach, requires you to do something different. For instance, one of the systems that...

Yea, that's what I said, but I just didn't use so many words saying it.
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