Risk Analysis

To succeed in trading risk assessment is paramount. Most of the stuff I've read on the topic stress the risk reward ratio. eg.. risk 20 pips to gain 60 pips, a R:R ratio of 1:3 (sounds great). Unfortunately this is far too linear, and risk is far more complicated. Risk assessment should also include for example, distance price must move and time given to achieve that move.

So we need to "work out" the probability, that the price we want, will be hit in the time horizon allocated.

An example: ( All numbers are rough guesses, but just serve to illustrate the point )

Profit target Probability of hitting target in 30 mins

10 pips ------------------> 90%
20 pips ------------------> 80%
30 pips ------------------> 60%
40 pips ------------------> 40%
50 pips ------------------> 20%
60 pips ------------------> 5%

Obviously the market type (TREND or RANGE) and currency pair along with a host of other factors will affect these probabilities.

So... according to the above numbers

Risk:Reward of 60:10 = 60x0.05 : 10x0.9 --> 30 : 90 --> 1:3

Risk:Reward of 1:3 (textbook) = 0.9x10 : 0.6x30 --> 9:18 --> 1:2

As you can see from the above calculation, the "larger risk" turned out to be less due to the small profit target.

The bottom line: SMALL TARGETS ARE SAFER AND HIGH PROBABILITY, BUT TO HIT THESE TARGETS STOPS MUST BE WIDER.

Thoughts?

If we talk about some newbie traders provided with the latest trading set up and data, anyone can predict that they are going to loose all of their money. On the other hand if you took some professionals traders they will make some good profits for sure, so the main difference between both the conditions is Risk management. It is one of the most important parts of trading.

Juandesta,

Interesting thoughts there is just one problem with your theory. If in your scenario, your trade wins 10 pips for every 20 pip risk, you will have to have 2 successful trades to make up for one loss. Where as the other trader can absorb a single loss within on win and still be profitable. That's why we want the risk/reward ratio on our side.

This adds a new dimension of to your "simple" risk management, that of win:loss ratio. Or, others may call it accuracy of entry signal. Still others call it your "edge". If your entry signal wins 55-60% of the time then you must figure that a loss will come along sooner or later (probably sooner). If your risk managment has an "updside down" risk:reward ratio, then you are left trying to recover the profit of at least two trades PLUS show a profit for the day. For your proposal to work, your entry signal must show an accuracy rate of 95% or better!

Now imagine 2 or even 5 losses in a row, which is not unheard of in any edge. Now your are left trying to find 4-10 successful trades just to break even. Is this starting to make sense?

Your issue of time is a valid one, and I would suggest that you use the time issue as part of your exit signal, to take a trade off the table with at least a small profit at your time limit.

My personal feeling is don't exit until you receive an exit signal, and make sure your stop is just outside this range. Then ride your trade until the market tells you to get out. Shoot for those 60 pips...you may be surprised at how often you hit it. You may also want to find a place or a signal that tells you to "split" your trade. Take a portion off in profit and raise the stop to break even. This removes risk and locks in profit much sooner than your scenario and keeps your edge on your side of the odds.

The other side of that is to exit when you have your exit signal...religously. This will keep some small profit or limit you to a small loss, but you will definately avoid the big stop out much more often. A stop loss is a fail safe NOT an exit strategy.

Well just my opinion...I hope you find something of value

I do appreciate all of what you have said. But i find that I do better with my system (I've experimented with may different Win:loss ratio's). The point I was trying to make is that if there is one thing that is almost certain, it is that the market will fluctuate along its course (except during strong spikes). Using short targets increases the chances that you'll get the target, and yes, it does increase the drawdown on individual trades. Basically it increases your win:loss ratio. You can't separate chance of hitting a target from the pip amount risked. They are not mutually exclusive. One affects the other.
I see you have read Trading in the zone. It's also one of my favorites, and I agree with much thats been said in that book. In particular that "every market moment is unique". This diminishes our "predictive" power. I find the only thing that I can predict (if you can call it that) is that the market is likely to fluctuate by at least 10 pips either way along its course. There are very few instances where this does not happen. I find it like a slot machine... it takes your small change often, and pays out large infrequently.
Guess what I'm trying to do if find out if the textbook advice is sustainable. For me it just got me killed.... Maybe this is why 95% of traders fail? They say traders are terrible at taking profits. Short targets eliminate that problem.

Juandesta. Yes I have read that book and yes I do believe in the wisdom it contains, however, my response was not based on my understanding of market theory or psychological theory, but more from experience. If you have understood the book, then you know that "you don't need to know what's going to happen next to make money". Your "predictive power" as you put it becomes irrelevent. What matters most is that your signal (1) has an edge and (2) you follow your edge. All that is left is that you manage your risk, which is where this whole thing began.

Placing your risk/reward ratio upside down will only lead to loss. I say this not because I've read but because I have experienced it...however unfortunately. I wish to save you that pain and hope you might learn my lesson sooner than I did. NO EDGE IS CONSITENT 95% of the time. It just isn't. I don't care how much care you put into forming it correctly...sooner or later you WILL have a series of losses, that will turn your 10 pips profit into 100 pips loss. ALL EDGES LOSE!

The only reason we are still here to discuss it is precisely because we control the down side and always shoot for more profit than loss. This occurs on each and every trade. This is not because the books tell us to but rather because this is the reality of our business. Losses happen. Try not to get sucked into the idea that 95% of your 10 pips gains will out weigh 5% of a loss that is double your wins.

Another quote from Trading in the Zone, "there is a random distribution of wins and losses across any set of variables that defines an edge". Meaning you never know when a string of losses may occur. If you expect a consistent 95% string of wins, and ONLY 5% losses, then another winning streak you are sadly mistaken. You may experience 5% losses, then 10% losses, then 25% losses before you next winning streak. IF your account is still there after this brutal pounding you will eventually see that making sure you win more on each trade than your risk in loss is essential.

You need to look at the range statistics to accomplish what you want to do.

You can't expect to make more pips than what is usual.

http://i43.tinypic.com/246l655.jpg

Gspajon. All that you say makes sense.... I'm still fairly new to the FOREX. Been trading for only one year. Guess you try all different avenues during the journey. Recon you are probably right... will give it some thought.
Thanks for the input.

Toddfx. Could you elaborate? Don't understand what you're trying to get across...

I am not sure what you are doing is risk management. It looks more like statistical analysis of a trading method. Here's a chart showing money/risk management.

http://i42.tinypic.com/2ewnxwx.gif

I look at it this way. If price movement was a random walk (which it's not, but it gives me a starting point for my thesis) then win rate and win size (return:risk ratio, or RR) would be exactly inversely proportional to each other. e.g. if we increase our TP/SL ratio from 1:1 to 2:1 then the SL will be hit twice as often, reducing our win rate accordingly. So for a simple TP/SL exit system to provide an edge in itself, it must exploit some non-random element in price movement, to overcome what would otherwise be an inherent equilibrium between win rate and RR. Of course all of this ignores transaction costs. I have written EAs to test random entries using different RR ratios, and have found it virtually impossible to gain a statistically valid edge (one that's capable of overcoming costs) by merely attempting to optimize the RR value.

Of course exits can (and generally are) more complex than this. For example, we can scale out of trades, and/or use a trailing stop. Given that long trends occasionally occur, it may be possible to gain some kind of edge by containing losses with a tight stoploss, and then letting profits run unrestricted. Eventually a 'home run' trade will compensate the trader for his patience. Another approach is to scale out at potential reversal points (e.g. S/R or Fibo extensions). If price occasionally reverses at or near these points, more often than 'randomly', then the lower number of wasted pips will contribute to eventual bottom line, and therefore provide an edge.

Apparently there are profitable scalpers whose SL > their TP, but their win rate is high enough to attain positive expectancy. Anyway, whatever way we cut it, the profit factor (win rate x win size) must exceed 1.0, after costs, otherwise we have a negative expectancy method, which no amount of MM or discipline can rescue.

Many traders seem to believe that "the money lies in the exits", but nobody has ever been able to explain how, at least to my satisfaction. For me, the entry needs to put me on the right side of a move more often than not; hence being fanatically selective about my entries is where any edge, that I might have, lies. (In fact, if I was even more selective, I would be more profitable – almost all of my losses stem from my impatiently trading "B-grade" setups). If price moves in my forecast direction, then the probability of reaching a TP before the SL is improved, overcoming the equilibrium that I mentioned; hence the entry is providing a real edge.

I will try to explain further with an example. One profitable approach attempts to catch a bounce at multiple confluences of different types of S/R (prior candle highs/lows, flipovers, floor trader pivots, Fibo retracements, trendlines, round numbers, whatever). Then, anticipating the bounce, the trader sets a tight SL, leading to high RR trades, and consequently attributes his success to his exits. However, I see it differently. If the entries were made at points other than the S/R confluences, the approach would lose its cutting edge. Hence I would attribute any success to the entries. The win rate still needs to be high enough to deliver positive expectancy.

Hanover...Well spoken! A selective entry that proves an edge in the market also improves the win/loss ratio, thereby adding weight to the argument that making your expected risk smaller than your expected gain a winning combination.

It is not JUST RR or win/loss or entry, it is all three that keeps us profitable. Bravo Hanover!

Thanks for your reply. It's always reassuring to find a like-minded individual in this business.

I think some of you guys are restricted too much by the more traditional trading wisdoms and mantra written in books, there's nothing wrong with thinking outside the box.

There are all sorts of things to take into consideration when assessing the viability of a strategy not least of all probability, a negative risk:reward ratio on an individual trade doesn't automatically mean the strategy will be unprofitable in the long term. Unfortunately the market isn't so obliging as to meet your risk:reward requirements just because you want it to, in the short term statistically it's more probable for a 10 pip target to be met than a 60 pip target.

It wouldn't be improbable for an intraday trading strategy which targets for example 10 pips per trade with a wide stop to have an extremely high win:lose ratio but that's not really important. Why are you focussing on the risk:reward of individual trades when it's unlikely any two trades will be identical, shouldn't you be more interested in overall returns across say a month?

Pipmut. Thanks for the reply.

I've been using this technique with a negative R:R ratio for some time now and find that so far it has produced better results for me. I look for specific entries and go for small targets. This means my exposure to the market is reduced because my targets get hit quickly, sometimes within minutes. It also makes sure that I take my profits and don't get too greedy. I find taking profits to be a major problem for many traders, people are always tempted to go for a few extra pips which can get them into trouble. As far as the conventional advice goes, I have no problem with it. It makes sense on paper, but in reality it does not translate into money for me. Using my short targets I manage to get a very high hit rate, and over time has yielded positive results. In fact I find my results are far more consistent using this method. With traditional method I find my account slowly bleeds away.

Has anyone else tried using negative R:R ratios with success?

Question:

When evaluating your risk, besides the amount of money at risk per trade, what do you look at?

Some things I look at:

1) Time of day
2) Economics announcements pending
3) Currency being traded
4) Daily range
5) Distance price must travel to hit my target
6) News
7) Volatility
8) "Trend" of currency being trades
9) Fundamental outlook
10) Leading indicators/Inter-market analysis. Gold, Oil, Dollar index, Vix, Put-Call ratios
11) Emotional state

and there are many others....

It works for you and you're happy with that style, that's what is important in my opinion.

I've found many traders have more of a problem taking a loss not so much taking a profit, just don't fall into that trap whatever you do otherwise as you know yourself, one major loss will eat all your profits and then some! Inverse is fine as long as it's not out the wazoo!

If I were you I would try not to get into the habit of automatically taking small profits, let the market decide. For instance you might be in a trade which goes into profit quickly and seems to have momentum to keep it going in your direction, it would seem a shame to close it out early. Maybe use a (mental) trailing stop and follow the trade locking in profit as it carries on in your direction, and perhaps when you've locked in the pips you would have taken originally then set an OCO limit/stop and leave it to cook, it costs you nothing and your original pips are safe.

There are countless ways to trade profitably and no-one has the monopoly, conventional wisdom is often turned on it's head in all sorts of things.

If it consistently makes money then it simply can't be wrong!

(Not meant to sound patronizing, you probably know all that stuff already )

Having a system helps every trader when it comes to profit, however you still have to find an edge that allows you to exploit the few good trades. Hanover already explained "Eventually a 'home run' trade will compensate the trader for his patience". This is a very true statement, what has helped me is to breakeven as much as possible, eventually that good trade appears and thats how profit is created. It doens't happen to often but it only takes a few trades a week/month to gain good pip amounts and cover the losses.

Your Dragon Money Management indicator seems like a very useful one. Could you please post it?

Thanks pipmutt, no offense taken.
What you said about letting the market tell you when it time to get out makes sense. When 'dancing' with the market it's best to let it lead, but your signal to exit needs to be objective and give you a fast heads up. In the markets that trade through central exchanges tick volume can be useful for this purpose. Eg// When long ticks of -1000 = exit no questions asked. Is there anyway to gauge order flow in the forex?

That's a great description, "dancing with the market"

There are a couple of threads on that subject here and here which may be useful although I've never really bothered as I don't think it can be all that accurate.