Risk/Reward Calculation

[n4j]

Hi All

How do you folks calculate Reward so that you know when to exit a trade?

Currently, I am trading through an Alpari Demo Account using the 3 Ducks system...

I am able to place stop losses so that I have no more than 1.5 to 2% of my demo capital at risk in any one trade. When placing the trade I also look at potential support levels and recent lows and make a judgement on these. I am pretty well OK with stop losses, so far. That is, I have it clear in my mind why I am placing the stop at the level I choose...

On the reward side, what I am currently doing amounts to not much more than a wild ass guess. I am basically using a ratio of 1.5 to 2 times the risk. But, for no good reason. In my journal I have started writing down the reasons why I set a stop at the level I do. When doing the same for a limit to exit a trade, the reasoning is not really there. I look at previous highs and obvious nice round numbers where there may be resistance, and set a limit so that I get out slightly early of these levels, but that's about all. If I can get a reward of 1.5 to 2 times the risk within these parameters then I place the trade.

However, this has led to me exiting some trades too early (because I don't have a solid enough reason to stay) or allowing a trade to run and ending up turning a winner into a loser because of what turns out to be an unreasonable reward expectation.

So, what do you folks do?

Also, what do you do in your spare time - when your systems are not showing up any trades? Play golf, watch the screen and wait, research new systems, research market background, watch daytime TV, have a nice cup of tea
and a ginger nut?...

Many thanks in advance.

 

[Adamus]

I base my risk analysis on an estimation of my biggest loss. I'm looking at a portfolio of several different futures, although in forex it's not so different.

If you buy Euros, there is always the possibility however insignificant that your Euros will then just vapourise in a major Black Swan. You can get locked in, no-one takes your bids during the freefall and you're forced to take big losses.

I can't think of any recent Black Swans in the Euro but there must have been a couple, and of course your worst loss is always in the future.

But this true worst case scenario might obviously not happen while you're trading, and in fact if you knew it was going to happen, you wouldn't trade. So that's your first major risk that you have to accept: you might just get completely wiped out.

That though is all psychological and doesn't help formulate a risk management strategy. I generally look at the last 20 years in all the markets I'm going to trade and take the biggest move as my theoretically biggest loss. Plus maybe 50%. And that's the amount of capital you should commit to each trade.

 

[n4j]

OK, thanks Adam. There's a lot to think about - liquidity, time frame you're trading to name but two. Would you actually trade like that though, or would you have a stop-loss (mental or physical) at a level closer to the price you paid? I realise that a stop loss is no guarantee that you will get out if as you say, no one wants to take your trade, but by trading a market like EUR/USD, the risk of this should be tiny. Or am I being naive?

Thanks again.

 

[Adamus]

Look at it like this: you must have a system in which you have faith that it'll be profitable, before you look at risk management.

You can't hope to trade successfully if you don't have a system. Although the word 'system' is wide open to interpretation, especially if you are trading on fundamentals, you still need one. It's basically knowing what you're doing.

So preferably whatever your system, you should have a track record, be it a real trade history, paper trading, or back-testing. Then you have the info to work out what to do about risk management.

First off, you can't use risk management to make an unprofitable system profitable, that's logical.

Secondly, the graph of risk to reward is not linear. There is an ideal point where your return will be maximum. If you go far beyond that and use too much leverage, there is also a point where your risk of ruin is 100% for any particular trade history.

I learnt this from Ralph Vince's the Mathematics of Money Management, but despite being very useful, I found the book badly written. I haven't found any other literature though that covers it better.

There are other ways of doing, lots of rules of thumb, but they're not rigorous. But then again, since you can't eliminate risk and make a profit, how rigorous should you be? Knowing you were rigorous when you're ruined isn't much consolation.

 

[n4j]

Many thanks again Adam. I really appreciate your comments. I'm going to do some more research into risk management now...

Best regards

 

[nexttothemoon]

I'll also add that I have read several books and several smaller articles on money management and agree that money management is a much greater element to successful trading than any fundamentals/technicals/entry/exit signals. You need to have an idea of what your maximum theoretical risk is in each trade and plan for the worst case scenario in every trade you take. A common rule of thumb is that beginning traders should never risk more than 1-2% of their portfolio value at any time on any trade. That level seems conservative to some traders and still high to others (usually more experienced traders who have seen positions fall apart on them over the years).

Plan for the worst at every level when you trade... have a backup computer system/internet connection/phone line for mechanical failures so you aren't stuck in a trade and flying blind. Have stop losses built into your trading plan so you have an automatic point where you are out of a trade that's tanking far beyond expectations (stop losses certainly aren't always perfect but are a step in the right direction).

Also... make certain your psychological makeup is such that you can cope with huge losses that WILL inevitably occur in trading... especially when starting out. Paper trade and backtest your trading strategies thoroughly and then trade very very small with real money and see how your mind handles losses. They can be demoralizing and ego crippling for many leading to emotional problems so it's better to find out with small amounts of money rather than money you can't afford to risk.

Read some of the money management books by the likes of Ralph Vince, Ryan Jones and Van Tharp as well to give you some ideas and a basis for what money management styles are most suitable.

 

[RubenE]

First off, you can't use risk management to make an unprofitable system profitable, that's logical.

It depends on what you mean by 'unprofitable'. If by unprofitable you mean that with poor risk management after an x number of trades the netto result is a loss then you actually can make an unprofitable system profitable.

Best regards,
Ruben.

 

[Rhody Trader]

It depends on what you mean by 'unprofitable'.

He means a system with a negative base expectancy, for example a system with a 1:1 risk/reward ratio and only a 45% win rate.

 

[Rhody Trader]

How do you folks calculate Reward so that you know when to exit a trade?

You're doing analysis to determine where your negative exit point is (stop). You should be doing the same for your positive exit point. People get caught up in R:R ratios too much at times. When looking at a trade your analysis (or system) should provide you an idea of where the market will go if things work out. That's the reward side, not some arbitrary figure. (Note: Some methods, like pure trend trading, don't have an easily identifiable target exit point.)