Introduction
Whatever we create, whether it is trading strategy, risk management system or anything else, our philosophy is to do it as simply and as practically as possible.
Whatever we do is supposed to serve us and not to confuse, exhaust or distract us.
We consider a risk management system to be the most important aspect of successful and profitable trading.
Please notice the word 'system'. It is not there by accident.
What is a system?
It is simply a set of rules.
Some of them could be hard (which should never be compromised) and some of them could be soft (they could sometimes be compromised and we may decide to call them guidance).
Do systems make you a more profitable and successful trader?
Our simple answer is YES.
Risk per Trade System
You may decide you will risk 2% of your equity per one trade as very maximum which is widely recommended as optimum especially if you manage your own capital.
Tip:
It is beneficial to use 'stop loss orders'. Such orders could be either send to your broker (after they run on his server so your trading platform doesn't need to be online) or you may decide to run such order as expert adviser on your platform (in such case your platform must be running on your computer and must be connected to internet or you may decide to do both.
Is the using 2% risk per trade rule alone enough for simple and practical 'risk per trade' risk management system?
Certainly not.
There should be another two fundamental aspects taken into account:
1. Correlation
Practically there is no difference between placing two highly correlated trades or placing one trade of double size (in terms of overall risk).
Therefore if you decide to enter two highly correlated trades you need to cut down the risk per each trade by half.
What are the highly correlated trades:
In regards to our philosophy of being maximally simple and useful we will not bother you with complicated math as it would be waste of energy and time with little impact on the quality of the result.
If the instruments correlate 80 or above we consider them as highly correlated.
If we intend to place two trades of highly correlated instruments (correlation 80 or above) we cut trade size of each such trade in half.
If the instruments correlate below 60 we consider them as uncorrelated (we see this correlation as likely accidental or insignificant) and therefore the trade sizes of such trades doesn't need to be adjusted.
If the instruments correlate 60-79 we see them as moderately correlated.
If we decide to place two moderately correlated trades we use ¾ of the maximum risk per one trade in each trade.
How to find out correlation of various instruments?
There are plenty of tools (correlation calculators) online.
Tip:
- Use correlation values on time frame you trade (If you trade 'daily chart' use correlation calculated on daily charts)
- If there is period you can choose we recommend to use period of 50 (days, hours, weeks act).
2. Risk/Reward Ratio
If you decide to place trade with potential risk of 2% of equity (loss limited by 'stop loss level' which could secured by 'stop loss order' or just some kind of alert) and potential reward of 2% (profit taking determined by 'take profit' level) then your risk reward ratio = 1 (2% risk/ 2% reward =1)
The statistical probability of winning randomly placed trade with risk reward ratio of 1 is 50%
If you decide to place trade with potential risk of 1% of equity and potential reward of 2% then your risk reward ratio = 2 (1% risk/ 2% reward =2)
The statistical probability of winning randomly placed trade with risk reward ratio of 2 is prox. 33% (1/3 probability of winning and 2/3 probability of losing of trade)
Tip:
We recommend placing trades with risk/reward ratio equal or higher than 1 (so trader isn't risking more than his potential reward is). Plainly said it is difficult to be profitable when using higher risk per trade than is your potential reward.
Although the statistical probability of winning randomly placed trade doesn't equal expected probability of winning trade, we strongly believe the risk reward ratio used should be reflected in trade size (having partial influence).
So you may decide, based on the section 2 ('Risk Reward Ratio') this (hard) rules:
- Never place trade with risk/reward ratio below 1
- Use full trade size for trade with risk/reward ratio 1.5 or bellow
- Use ¾ of the trade size for trades with risk reward ratio 1.5-4
- Use ½ of the trade size for trades with risk reward ratio higher than 4
3. Combining correlation and risk/reward ratio
This should be straightforward and obvious so in regards of maintaining maximum practicality of this article we will go straight to the example:
You intend to place three trades while using maximum risk per trade of 2%:
Correlation between instrument A and B is 83
Correlation between instrument A and C is 72
Correlation between instrument B and C is 55
Trade (traded instrument) A with risk reward ratio 1.5
Trade B with risk reward ratio 2.6
Trade C with risk reward ratio of 4.3
The trade sizes of each trade will be adjusted accordingly:
Conclusion
You will risk 0.75% of equity in trade A; 0.75% of equity in trade B and 0.75% of equity in trade C
Tip:
Plan your trading. It is difficult to know for certain which trade(s) you will place in the future (in case you are not placing them simultaneously) but if there is higher probability you will execute some trade (s) then act beforehand accordingly (this impact only correlation issue).
Note:
You may want to read 'Risk Management System: Simple and Practical Manual Part 2/3: Portfolio
Vlastimil Selbicky