Hi ETers, I read that many times but i am wondering is there any math behind this common statement? Let us immagine this situation: You have a risk/reward ratio = 1/1 . profitable trades 55%. What do you think the optimized risk you should take for every trade? On another situation, if you have 99.99% propability that your trades is profitable. What do you think the risk you should take for everytrade,relative to your account?
oh, its a stupid rule. 30% risk per trade is best. 3 trades losing and its exactly why you should never risk only 2% per trade.
Never, I say never, never trade with risk/reward ratio = 1/1 unless you are more than 80% profitable. This is the situation that has killed the best of traders: Trade 1 = +1 Trade 2: = +1 ..................... Trade 9999 = +1 Trade 10,000 = -100,000 (remember LTCM?) Probability to win = 99.99% Result: total ruin My rule: never risk more than 0.2% of your account on a single trade. If you can't do that, simply do not trade or the market will make sure you don't trade.
http://en.wikipedia.org/wiki/Kelly_criterion In your first use case of risk/reward ratio = 1/1 and profitable trades = 55%, the optimal bet size would be 10% of your account value. In your second use case, you need to specify the odds on the winning bet.
Most people cannot explain where they get their risk/reward numbers from. "My risk reward is 1:2" = "I'm going long the ES @ 1,200 with a target of 1,210 and a stop loss of 1,995." But they can't tell you why they think they're more likely to hit their profit than their stop loss. Why 1,210? Why not 1,211 or 1,209? etc.
The market doesn't know or care where you entered, so your stop shouldn't be related to your entry, but to a significant market event.
1% risk per trade does't work. I make 20 swing trades in one year, 40% percent is losers and the rest is winners. so I end up with 8 losers of 1% and 12 winners of 2%, that gives me a return for the full year that is less that 15%, sorry that is not good enough, even buy and hold is better, I need more risk.
Here's a screenshot from a paper I wrote on the subject. The issue is that, even with a 99.99% probability of winning, you still have that 1 in 10000 chance of losing. And when you do, you'll have to make up whatever you lost. So, even at those odds, I would never risk 100%. Or else every 10,000 trades I'd be wiped out (assuming every trade had those odds). Likewise, even with a 55% chance of winning on a trade you still have a fairly good chance of having a long string of losses. I mean when was the last time you flipped a coin and were surprised to see heads like 8 times in a row? It does happen, and the mere possibility of it happening means protection from it is mandatory for long term survival. Aside from those two instances, the amount you lose vs. amount you need to win to get back to even is logarithmic as the attachment explains. Finally, don't confuse risk with "amount traded." If I buy a stock for $100 per share and set a stop at $99 per share, that's only a 1% risk. I'm not risking $100 because I put $100 up to purchase the stock. Rather I'm only risking $1 because that's where I redeem the remaining value of the stock if I'm wrong (of course I'm leaving out commission, slippage, and spread for simplicity). I assume you knew this already, but just wanted to be sure. Hope you find this helpful.