Which risk management strategy do you think is better?
There are two concepts:
1. we assume $20,000 per contract and always trade the max size calculated this way (e.g. for $100,000 we always trade using 5 lots)
2. we assume 0.2% risk per trade and adjust the clip size depending on the stop level (e.g. for $100,000 we can risk $200 per trade; tick value $10 - if the stop level is 4 ticks we trade 5 lots; 2 ticks - we trade 10 lots).
Strategy 2. has the advantage of potentially creating huge winners but with less certainty. With strategy 1. the risk will vary slightly - on one occasion you will use 2 tick stop, then a 4 tick stop - both trades with the same size, which results in different loss in monetary terms.
One decides this on the basis of expectancy: each type of set-up one trades has its own expectancy (which you need to know, or at least to be able to estimate reasonably reliably), and you'd presumably want to risk more capital in the types that have higher expectancy?
I think this is related, mostly in the general term of money management for daytraders. I wrote this article a few years back after observing many different day traders in the futures field and I think it may provide some food for thought, ideas for risk per day type of approach. Survivor day trader.
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I think you may be asking the wrong question. The question you want to ask is what is my risk of ruin running a certain amount of risk. You will often hear not to risk more than 2% on any single trade. However, just simple logic should tell you that if the risk of ruin is miniscule at 2% then it would be very low at something greater than 2%.
The other part that I think is implied in your question is regarding setting the stop loss based on a hypothesis or volatility basis . On most systems you will need to have a stop of at least a minimum size or it won't work. So, yes that would be a part of the position sizing aspect.
In your first method, you share trading a certain number of contracts for the account size. This type of approach would be useful for active discretionary day traders where calculating some risk per trade or whatever isn't realistic. It is often counter productive to focus too much on where to put the stop loss or whatever. Also, that would be a method if you already found the optimal stop loss for sizing up the account as it grows in value.
The second method is not going to be very useful, really except for much larger accounts because on small accounts you're not likely to to be able to risk such a small amount.
So, it is often useful to have a max daily loss limit but also you might have a max contract limit too. The reason is that it would be a distraction to calculate the risk.
When thinking about stop losses, it might be useful to consider 3 aspects
1. Probability of loss vs win
2. Probability of a loss of a certain size. Realized risk or heat taken.
3. Max loss possible.
You lost me there. I thought for sure a volatility based system in terms of R was what "The Turtle Traders" used. Also that is given a lot of coverage by Van Tharp. So I am probably mis-interpreting what you are saying. A surface reading you seem to be saying that with a smaller account you should take large risks as a percentage of your account size? What am I missing?
Turtles was a large diversified system. You have to factor in your probability of winning/losing on any trade beyond anything else. If you have say 5k account and wanted to follow the 2% risk rule, you'd only be able to risk $100 on any given trade. Very few futures systems will work with stop losses that small. Even 10k your stop loss is only $200 which is again below what most systems require to work properly.
The way you are thinking about the problem is interesting but probably not very productive.
In reality, a trader/developer develops a system. They do analysis to see what stop losses are possible. Those stop losses determine how much you have to risk per trade. Then you can you can do risk of ruin or max DD analysis to determine if you are willing to take the heat to trade system.
The second method might again be more useful for portfolios or whatever. But once you know the stop loss required you can easily work back to determine how you want to scale the system to achieve a certain DD result.
Just remember, the stop loss is not what determines how much you are making --
In fact.. here's what it really looks like
(STOP LOSS REQUIRED/ ACCOUNT SIZE AVAILABLE ) * 100= PERCENTAGE OF RISK PER TRADE
Your stop loss and account size are more or less filled in by your situation. When you scale the system, you can scale it by requiring a certain amount of money in the account i.e.. trade 1 contract with 10k but wait for 15k to add 2 or you based on percentage of risk of the account. It's really no difference. They are equivalent.
If you do have a system that uses widely varying stops then you would probably want to limit both # of contracts and total risk on the trade. You might, also, as suggested vary the risk based on the confidence, quality of the trade. Keep in mind, also, a possible hidden factor which would be the win ratio. I am not really sure that it makes sense your win ratio would be equivalent if you did have a system that used stop losses that varied significantly as it would almost be like different systems.
The stop loss, also, is not really where systems derive their profits. So spending too much effort on that aspect might be less productive than other aspects.
Last edited by tpredictor; December 11th, 2016 at 10:38 PM.
Thanks for that. What you are saying is in syc with what I have read. The one point where I disagree with you is watching out for that risk of ruin. The exit and bet sizes have been shown to be critical to success and I personally find that about half of my stuff hits the stop before an exit signal, but that is just me.
I would quote traderDante (Tom Dante) as to the importance of not losing your capital but I am sure his soccer hooligan english would get me instantly banned.
I have read several pros (Peter Brandt comes to mind) that say you really need to match your market to your capital. Afteerall, if position sizing was straightforward Van Tharps booklet wouldn't be $250 used, and there certainly wouldn't be so many vendors offering magic bullet position sizing software.