I have been thinking about writing something on money management, I just didn’t know where to start. Of course, I am an amateur on this topic, I am just sharing materials I have learned.
There are times I read traders’ blog who revealed their risk reward ratio when making certain trade. Some traders are trading with 1 R in order to earn 0.3R (basically, risking $100 to earn $30, that’s the idea). Since there is nothing right or wrong in trading business, I am not arguing if the trader is doing the right thing. I am interested in looking at some simple mathematical details of this risk plan.
Just how much accuracy is required from your system in order for you to be profitable after certain number of trades when you are risking , say, $100 to earn $30 each trade? I found an excellent spreadsheet from Kreslik.com (An excellent forum, with some great traders sharing strategies, programming etc). The spreadsheet can be found here. moneymanagementchartupload.xls
Let’s take an example, risk amount $100, profit target $30.
As you can see, with this risk/reward ratio, you will need a system/methodology that gives 80% accuracy in order for you to be profitable.
A system with over 80% accuracy? Well, I believe it does exit, but I have no luck to see it so often. Most of time, I will be happy if my system gives me over 60% accuracy or sometimes, just around 55% accuracy.
This time, I am risking 1 R in order to earn just 1.5 R (risk $10, to earn $15).
Here is the result.
Basically, it is just like a coin tossing game, I need 50% accuracy in order to be profitable.
How about risking 1 R to earn 1 R? No. Remember, commission kills. For example, we assume each trade , $2 is required for commission. With 1:1 risk reward ratio, over 100 trades, we are still at the losing end if our system is unable to produce 70% accuracy. You can try out different Risk/Reward combinations in the spreadsheet.
Some simple calculations do help traders to understand the nature of trading. If you think it is ok to risk a bigger dollars to earn a small profits, make sure you have a high accuracy system that really pays you.
A great article on this topic can be found here. (Link from Kreslik.com)