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real world stops and risk reward ratio.

  #7 (permalink)

Cedar Park Texas USA
Trading Experience: Intermediate
Platform: TOS, IB
Favorite Futures: NQ, CL, GC. YM
Posts: 29 since Jul 2016
Thanks: 5 given, 15 received

mcteague View Post
Trading is like any other form of gambling in that we should only place trades (bets) with a positive expectation. The positive expectation is determined by the chance of winning and the risk reward ratio. (stop to target)

However I find it is often necessary to place stops more widely than I might think technically accurate. This is to avoid market noise and random news based events. When I first started trading the E-mini I got stopped out like 4 times in a row. Even though the chart said that was where risk should be; I just got whacked over and over. So now when I mostly trade stocks I move my stops a little lower to avoid that. And often just go completely stopless, as I only trade high quality stocks.

If the trade is going against me I just exit. So I never really hit the wider stop. However this does not change the fact that the math is now wrong. On paper using the actual stop and target I am now in a trade with an insufficient expectation. I am making a bad trade. But in the real world it is fine.

What is the proper way of addressing this problem so that you avoid possibly fooling yourself and entering weaker trades than you should? Can I make the math right while still compensating for the real world?

I've been looking into this topic in depth (and don't have a great answer yet).
Here's is somethings that seem to make sense based on the testing I've done.

1. It depends on your time frame.. Holding a trade for 30 minutes vs holding a trade for 90 minutes will change how much risk
is needed to have to trade work. That is, if you calculated every outcome in the next 30 minutes, and then every outcome in the
next 90 minutes, you would find that average amount of risk to be larger in the case of 90 minutes, simply because the market will generally move more in 90 minutes than in 30 minutes.

2. In addition to your trading timeframe, the time in each bar has an effect. The market moves more (on average) in a 5 minute bar
than a 1 minute bar.

2. It depends somewhat on Time Of Day. For example, assuming you trade NQ, trading at 8:30 Central time would need a different level risk, than a trade executed at 8:55 central time. The opening is more volatile. Before a major report can be quieter.
Trading right after the Fed changes interest rates is another example of times where risk is different/higher than normal.

3. I've noticed a positive correlation between the range of each bar and the amount of risk required to have a trade work (assuming you
picked the right direction, lol) There also seems to be a positive correlation with volume. The higher volume tends to move the market more.

4. As with all things market related, there are examples and counter examples. Using statistics helps to see the general trend. Looking at risk histograms can be helpful.

Best of luck!!

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