How do you manage your risk??

[Deaddog]

Don’t want to hijack the Babes thread so I’ll start a new one.

Risk control is my favourite topic for discussion. It’s the first question I ask when anyone tries to sell me a stock selection strategy or financial planning. How do you control risk?

Never seem to get a satisfactory answer.

Here are my risk control rules:

Define your risk as the difference between your entry price and your stop.

Never risk more than 1% of your capital on any one trade.

I will hold a maximum of 8 stocks in my portfolio and will not exceed more than 25% of the account value in any one position.

Follow those 3 rules and you will never get a margin call.

Deaddog,
I'd drive you crazy but I'm getting more conservative with age. At one time 50% of my capital was in one stock. I thought "this is crazy" so I sold 80% of it. The stock was AAPL , that was nearly 300 points ago. Still have 15 stocks with a core of 4 that comprise 55% of the total. Reinvesting divs. is a big part of the current plan. It works real well in down years and none of the companies have lowered return or are in distress. And I don't short.

----------------billy

Yup I understand the conservative strategy. I'm no longer accumulating. I spend my dividends. Thats why risk control is so important to me.

But back to the question at hand. How do you control your risk?

[hags]

Simple....math expectancy

hags

[billyjoe]

Don’t want to hijack the Babes thread so I’ll start a new one.



Yup I understand the conservative strategy. I'm no longer accumulating. I spend my dividends. Thats why risk control is so important to me.

But back to the question at hand. How do you control your risk?

Deaddog,
Are you now or have you ever been a prosecutor ? My attorney tells me not to take the stand.

---------------billy

[skiracer]

Simple....math expectancy

hags

I knew you were going to say that. I dont think anyone here knows of or understands the specifics of Risk/Reward or Math Expectancy.

[Deaddog]

Deaddog,
Are you now or have you ever been a prosecutor ? My attorney tells me not to take the stand.

---------------billy

Nope never a prosecutor:

However I take it, by your lack of a straight answer and taking the 5th, that you are using the "Hope and Pray" methodology of controlling risk.

I believe it was Ski who said “when you don’t tell the truth you are only deceiving yourself.”

[Deaddog]

Simple....math expectancy

hags

I vaguely understand math expectancy. Might be useful to define your edge. How do you use it to control risk.

Problem is a positive expectancy strategy may quit working depending on market conditions. Then what?

[skiracer]

I vaguely understand math expectancy. Might be useful to define your edge. How do you use it to control risk.

Problem is a positive expectancy strategy may quit working depending on market conditions. Then what?

I would say that risk/reward and math expectancy are what they are regardless of the market conditions.

[billyjoe]

How can positive expectancy strategy quit working? That's the point......it can't.

--------------billy

[Deaddog]

I would say that risk/reward and math expectancy are what they are regardless of the market conditions.

Well then I guess I don’t understand the concept as well as I thought.

Here’s how I see it.

If you have has a 1 to 2, risk to reward ratio, trading system; you need to win 33.33% of the trades to break even. If you have a trend following trading strategy and the market is moving sideways you probably won’t achieve the 33% win rate to have a positive expectancy. So depending on where we are in the market cycle the expectancy of any trading strategy may be positive or negative.

I don’t see where it is useful in controlling risk.

[skiracer]

Well then I guess I don’t understand the concept as well as I thought.

Here’s how I see it.

If you have has a 1 to 2, risk to reward ratio, trading system; you need to win 33.33% of the trades to break even. If you have a trend following trading strategy and the market is moving sideways you probably won’t achieve the 33% win rate to have a positive expectancy. So depending on where we are in the market cycle the expectancy of any trading strategy may be positive or negative.

I don’t see where it is useful in controlling risk.

risk vs reward doesn't change because of market trend or direction. It's the setup and the trade that determine risk vs reward. Once you have determined what risk vs reward numbers you can operate at then you can figure math expectancy for your system. Although my trading system and discipline are based on risk vs reward and math expectancy along with systematic entry, stops, and targeted exits Hags could probably explain it clearer in more understandable terms than I could so that you would be able to understand it easier.
Below is a pretty precise and clear explanation of the concept with money management totals although this might be a bit complicated to understand at first. This is not my own explanation but is basically what I am talking about and I'm assuming what Hags is speaking of when he mentioned Math Expectancy or some derivative of it.

« Calculating Stop loss price using Risk & Reward|Support and ResistanceDollar Cost Averaging Investment Strategy vs. Lump Sum Calculation »
Trading Expectancy and Risk to Reward Ratio Trading System analysis

This is tutorial regarding the analysis to a trading system and its relation to expectancy as well as the risk to reward ratio. This tutorial consists of the important financial equations that the trader needs to know. This is equation 1 which the standard formula for computing trading expectancy:

Expectancy = (%win * average win) – (%loss * average loss) (equation 1)

Supposing:
Risk/Reward ratio is 1/3 then Average loss/Average win is 1/3. Risk to reward ratio varies from one trader to another. Some will target 1/2 or 1/5. 1/3 is a common standard.

Then equation 2 is:
average win = 3* average loss (equation2)

Supposing the trader is targeting $100 net profit per trade. So this equates expectancy to $100
Also:
%win + %loss = 1

Then equation 3 is:
%win = 1- %loss (equation3)

Now simplifying equation 1 with equation 3 forms equation 4:
100= ((1- %loss) * average win) – (%loss* average loss) (equation4)

Simplifying equation 4 with equation 2 forms equation 5:
100 =((1-%loss) * (3*average loss)) – (%loss* Average loss) (equation5)

If a traders needs to earn at least $100 net profit per trade with a risk to reward ratio of 1 is to 3. The following is the relationships between average loss and %loss (simplifying equation 5 to solve for average loss, equation 6)

100 + (%loss * Average loss) = (1-%loss)(3*average loss)
100 + (%loss * Average loss) = 3*average loss – 3*average loss* %loss
3*average loss – 3*average loss*%loss – (average loss * %loss) =100
3*average loss – 4*average loss* %loss = 100
(average loss) (3 – 4 * %loss)= 100
average loss = 100/(3- 4* %loss) (equation6)

The following is the generated Excel analysis of the trading system: I did show the excel sheet because it would not copy but if you would like to see the excel spread sheet for the percentages you can go to this link to see it. It's worth taking a look at it and it would make things a bit clearer in understanding the process and the percentages.

http://www.stock-trading.me/2010/10/trading-expectancy-and-risk-to-reward-ratio-trading-system-analysis/

ANALYSIS and CONCLUSION:
It shows that:
1.) The trading system is NOT anymore profitable at 70% above for %loss. So if yo do backtesting or paper trading. If you target $100 per trade net profit and 1:3 risk to reward ratio, then you need to have a trading system with at most 70% loss to stay profitable.

2.) You notice that with constant risk to reward ratio of 1:3 and fixed net trading profit per trade of $100; if your trading system is a high % loss system, then you need to be prepared to lose large amount of dollars to stay profitable. For example at 60% system, you will be risking $166.67 per trade. From trading capital point of view, you need big starting capital to finance a trading system with high losing percentage. This will also combat drawdowns.

3.) The average win will also increase with high losing percentage. This means that in order to stay profitable (hitting your trading expectancy), you will be aiming for high profit targets. This might not happen in all stocks, especially that:

Average win can be expressed as:

Resistance price – Support price (equation7) for long trades or opposite for short trades. Then you need to find a stock that will be volatile or high resistance to support gap, which can be rare, in addition that it needs to be expensive stocks.

Example: If a certain stock will trading at $400 now and 2 weeks ago, it is trading at $200, and also this happens frequently, you can say that the gap is $200 so you can need to have a trading system with aimed wins at $200 or a 35% loss system.

If you have a high percentage loss system, then you will never hit profit targets in a realistic time frame for day trading (one or two weeks depending on your patience) because the gap is small and stock is not too volatile. Or if the stock price is too low ($5), it can take ages to make this happen.

[hags]

I vaguely understand math expectancy. Might be useful to define your edge. How do you use it to control risk.

Problem is a positive expectancy strategy may quit working depending on market conditions. Then what?

Math expectancy isn’t a trading strategy but more a reveal of ones trading prowess. Positive math expectancy shows the power to manage risk by concentrating on factors that produce positive math. With more and more trading the math results are concrete and confirm that you either can trade or you can’t. Once you apply the formulas to your past results your able to see areas of weakness that call for improvement. You can also apply the formulas to trading time periods, when trading seemed easy or hard, and note the mistakes in your trading intervals. If you go beyond math expectancy and calculate a Kelly value from your results you know exactly how much to allocate per trade. No over or under allocations….It’s trading in the know and a vital concept to understand.

hags

[Deaddog]

OK I think I have the concept figured out. We are all on the same page when we talk about expectancy.

I agree if you have a negative expectancy you should quit trading.

So the trick is to have a strategy that gives you a 1:3 risk to reward that wins more than 25% of the time. How simple is that?

Where I have a problem is not letting trades get to the exits. I tend to override the system. Take trades off at break even, cut losses short and protect any gains I might have made. What happens is that a planned 1:3 strategy turns out to be a 1:1.5 actual ratio and although I have a 39%win; 18% breakeven and 43% losses; My expectancy is 0.88%

All guess all I have to do in increase the number of trades I make.

So my problem is discipline. I’ll have to learn to set the trade and leave it alone until it hits one of the exits.

Something for the Old Dog to gnaw away on.

Thankyou Ski and Hags

[hags]

Post up your numbers Dog and I'll run them thru,

All I need is:

Number of Wins
Average Win Percentage
Number of Loses
Average Loss Percentage

4 simple numbers and a little math will reveal alot....and manage your risk eventually...

hags

[skiracer]

OK I think I have the concept figured out. We are all on the same page when we talk about expectancy.

I agree if you have a negative expectancy you should quit trading.

So the trick is to have a strategy that gives you a 1:3 risk to reward that wins more than 25% of the time. How simple is that?

Where I have a problem is not letting trades get to the exits. I tend to override the system. Take trades off at break even, cut losses short and protect any gains I might have made. What happens is that a planned 1:3 strategy turns out to be a 1:1.5 actual ratio and although I have a 39%win; 18% breakeven and 43% losses; My expectancy is 0.88%

All guess all I have to do in increase the number of trades I make.

So my problem is discipline. I’ll have to learn to set the trade and leave it alone until it hits one of the exits.

Something for the Old Dog to gnaw away on.

Thankyou Ski and Hags

risk/reward and math expectancy are important but the most important is the realm you were just speaking about and that's emotional control and your controlling the trade not the trade controlling you. controlling the numbers is the key and to do that consistently is true emotional control in life and in trading.

[TraderPlayerPerson]

Math Expectancy

I have some experience using math expectancy spreadsheets to input my # of winning/losing trades, avg win and avg loss. For me this was somewhat pointless. My trading was what it was. I tried to keep losses small and let my winners ride a bit more. I did find it helpful and informative to review my trades. I've mentioned this before here, but I found it interesting that I made 20% in a $10,000 trading account with only 20% winning trades. I lost 10% of the time, and I got out about even in 70% of my trades. I didn't count a 0.05% gain as a win. A winning trade was about 3-5% with an occasional 10-15% gain. A losing trade was about 1-3% and sometimes 4-5%. This was back when I first started trading in early 2010. When the market became more volatile I would use smaller position sizes. If you want to have a risk reward of 1:3, it doesn't mean you have to take every win at 3% and every loss at 1%. When I think I'm wrong, I get out quickly even if my maximum risk hasn't been hit. In my experience, this has been the holy grail.