We all try to find the strategies which offer best possible win probabilities. Yet, we often overlook another crucial component of increasing your odds of winning => risk management.
Today, I am going to show you how you can use a simple risk management trick to tilt the "Math" in your favor.
Would you like to increase the output of your strategy by 25% without doing anything extra? Imagine a 3R win suddenly increasing to 3.75R with no change in the strategy at all.
Consider this trade...
We are trying to setup a sell trade with a very defined -1R risk and +3R profit. If we were to loose this trade, we will loose 1% of our capital - and if we win, we will make 3% in return (3RR).
Here, we assumed that we'll exit the trade when price moves -1R completely against us. What if, we pivot our thinking and assume the trade is lost when price has moved -0.8R : because if the trade goes that much against you, there's a very high probability that it'll hit your stop loss too. There is no reason to pretend that it can still turn around at the last moment. Murphy's law truly applies here - "Anything that can go wrong will go wrong".
If we do really pivot our thinking, lets see how it works in our favor! The Stop loss is now updated and set at -0.8R So a win will still give us the same 3%, but the loss will only wipe out -0.8% from our account.
Now because our profit targets are still setup as per the original 1% trade, you can now see that we now get this extra reward if our trade hits its original 3R target The moment we draw 3R as per our new -0.8R stop loss, we get this - You can see how the 3R with -0.8R stop loss is achieved much before than the 3R with -1R stop loss (obviously)!
That means, the extra reward you got when the trade reached your original 3R - is additional profit which you now have - without ever changing your trading strategy! 3/0.8 = 0.75 (which is 25% of your original 3R target) 0.75/3 = 25% You now have extra an 25% reward for free! New RR = 3.75
This is a very beautiful math equation for yet another reason! Imagine you lost your trade with a -0.8R => the additional 0.75R you will achieve (for free) from another trade will extremely quickly cover up anything you lost.
As you can see, we can really use sound risk management techniques & Math to our benefit. This is called : Tilting the "Math" in your favor!
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An astute observer @Cryptological_Tactician mentioned a very valid point that once a trade is setup with -1R SL and +3R TP, the volume entered will always give the same output RR.
I want to clarify that I intentionally left out how the trade setup should be done - as it would have unnecessarily complicated the tutorial. However, I think I should address the above point
*How to really setup the trade?* - When planning the trade, plan using the original -1R SL and 3R TP - When calculating the volume, plan using the SL & TP of -0.8R. - When in the trade, hold the trade till your original 3R target (the one corresponding to -1R SL) - So the extra distance covered in profit to reach your original TP of 3R is the extra 25% reward as mentioned in the article.
I hope this helps in understanding the trade setup.
Cheers!
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Another way to implement this concept is to understand the max-loss concept. Lets say even if one was to simply move the stop loss to -0.8R after setting up a 1R trade.
In that case, the max loss one is willing to take is -0.8R and the if profit, it is 3R
Even though this seems like that we are simply tightening the stop loss, but over a large sample of trades, you'll loose less - thereby increasing your overall risk:reward.
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I would like to share a set of real life trades to prove this concept Last few days, I took the following trades : snipboard.io/muCP08.jpg
As you can see, my max loss was -0.8R Even though I won only 2 trades of 1.5R each and lost 3 for -0.8R each, I still have a positive 0.6R. Total wins = 3R, total loss = -2.4R
Had my each looser be -1R, this net RR would have been 0
0.6R / 2.4R = 25%
All else being equal, I eked out 25% more reward out of my trades - relative to my losses.
Thanks for sharing! If we understand it correctly, plan your trade with -1R loss vs 3R win, but place the trade with -0.8R loss vs 3R win. An interesting "mental" model. It's been featured on Editors' Picks. We are always interested in sharing risk management tips! Let's see what others say. 😁
@TradingView, Yes, that is a very accurate summary.
Thank you TradingView for selecting this as an editor's pick. I am honored.
Cheers!
TraderNeoh
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Hey Makuchaku! Thanks for the meaningful post. However, I do believe that the odds of getting stopped out increases accordingly too by tightening your stops ‘mentally’. As instead of putting your stop above/ below structure you’re now squeezing it a bit. When your SL is squeezed, it is now more identifiable and probably less reasonable. As the initial SL should be defined with a proper thesis behind. But again it’s from my personal POV. Amazing effort! Cheers.
TradingView
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@TraderNeoh, Thank you for sharing this and we're following along to see the feedback this post gets. Hey, kudos to @makuchaku for sparking the discussion.
Hi @TraderNeoh,
Yes, that's a very valid way of thinking.
However, the intent of this post was that wherever you choose to place your SL, also do consider the possibility of 0.8x SL
The difference of 0.2 is not much & probably won't interfere with your trade thesis - but helps both ways - when you loose or when you win!
I thought for a bit about whether I should post this - but I am too stupid not to post it.
Van Tharp stated that he was hired to teach traders risk management. He would go to them and have them participate in a marble game where they won more than they lost. they would start with a set amount of capital. Almost all professional traders ended with a complete loss of capital or a very severe loss.
The problem with the title here is that this is not risk management.
This is trade management.
Process:
Find the trade you like. Seykota said he put a chart on the wall and walked across the room. If he could see the trend he would do the trade.
After finding the trade, risk management is the next step.
Risk management is allocating the proper amount of capital to stay in the game.
Determining the maximum amount of capital then allocating the initial and future sums at/or stop loss is risk management.
This is not semantics.
Newbies should read Van Tharp.
Allocation of capital is risk management. Without a trading plan (Richard Williams turtle traders as a place to start creating a plan for risk management for example, or any trend follower ipod series metodology) the trader is doomed by capital misallocation.
and then there is developing a high expectancy system... etc etc.