Money Management Like a True Professional

Hi Trader,

Let me tell you a secret right away:

the percentage of winning trades of a trading system is completely irrelevant.

Put that way it may sound like a provocation, but you will see it is exactly so.

Let’s take it in order.

When we talk about Money Management we usually refer to how much to risk (Risk Management) and to how to manage positions based on the gains and losses achieved (Position Sizing models).

On top of this, a complete Money Management must also deal with “how much to gain” compared to “how much to lose” on each single trade.

Many traders put too much emphasis on the percentage of winning trades, without understanding that this says nothing about the quality of their trading system.

The truth is that you can easily lose money even with a winning percentage of 70% or even 80%, if the losses are so large that they wipe out the gains you brought home.

On the other hand, you can have a profitable system even with a win ratio (percentage of trades in profit) of 50% or 40% if you have nice winning trades compared to smaller losses.

This is what we call in the jargon Reward Risk Ratio, or better the Risk/Reward Ratio.

Risk/Reward is perhaps the most important figure to analyze for a good trading plan.

A trader who understands it deeply and applies it methodically greatly increases their profit percentages.

Myths About Risk/Reward

Before diving into the specifics of Risk/Reward, let’s tackle some widespread false beliefs.

1. Risk/Reward is useless

If you ever hear someone say that the risk/reward ratio is pointless, ignore them.

When we use Risk/Reward combined with another statistical tool such as the Win-Rate (percentage of winning trades) we get one of the most powerful trading tools we can have.

In short, if you do not know the Risk/Reward ratio of each single trade it will be impossible for you to trade profitably over time.

2. Good risk/reward or bad risk/reward?

How many times have you heard someone talk about a generic Risk/Reward ratio or a minimum R:R?

Even in popular trading books people often talk about a minimum R:R of 1 to 2 or higher.

The truth is that there is no good or bad risk/reward ratio in absolute terms,

it all depends on how you use it within your trading plan,

you can be profitable even with an R:R of 1 to 1 or lower, keeping well in mind that the more you lower it, the harder it will be to be in profit over the long run.

3. A bad trade does not become good by increasing its R:R

Many traders often think that by increasing the target or reducing the stop loss they get a better R:R and therefore a better trading performance…

Often it does not work like that at all!!!

Increasing the target points means that sometimes, or maybe often, the price will not manage to reach your target.

As a result, the percentage of winning trades will drop a lot.

On the other hand, tightening the stop loss so arbitrarily results in an inevitable increase of stops taken or premature exits from trades that maybe would have reached target!

If to change the Risk/Reward of your trades you do not respect your trading rules you are making a double mistake, a more meaningful reflection on your trading plan is needed, one that also includes your entry and exit strategy.

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Let’s briefly look at the basics of the Risk/Reward ratio

1. Calculating risk/reward

Essentially risk/reward measures the distance between:

• entry price – stop loss;
• entry price – target

and then compares the two distances.

Let’s say for example that the distance between your entry and your stop loss is 10 points and the distance between entry and target is 20;

the risk/reward ratio is 1:2

since 20/10=2

You lose 10 points or you gain 20.

This is the formula for a LONG trade:

(Entry Level – Stop Loss) / (Target – Entry Level)

For a SHORT trade instead:

(Stop Loss – Entry Level) / (Entry Level – Target)

2. Percentage of winning trades

When you know the R:R ratio of your trades, you can calculate the minimum win-rate you need to make money over the long term.

This is important because if your trades have a negative R:R you will lose money over the long term, unless you have a win-rate of 80/90%.

Here is how to calculate it

Minimum win-rate = 1 / ( 1 + RR )

Example: if you use an R:R of 1 to 1 your percentage of winning trades must be higher than 50% to be profitable:

1 / ( 1 + 1 ) = 0.5 = 50%

As you can see from the table you do not need an extremely high percentage of winning trades,

nor an R:R of 1 to 5 to be profitable in trading.

As long as the two parameters match each other, your trading will be on the right track.

Clearly it is always better to favor trades with an R:R of at least 1 to 1 or higher.

Conclusions

In this article we talked about minimum R:R compared to the Win-Rate factor,

of course all of this at a mathematical level is correct in an “Ideal Environment”

Unfortunately, not living in an ideal environment free of surprises, we have to keep in mind two very important things:

1. The cost of the various brokers’ commissions, which certainly affects the final results
2. All the unexpected variables that anyone who trades knows very well (slippage, connection drops, order entry errors, platform freezes and many others… 🙂 )

SUERTE AMIGO

Tiziano Brunno Tradingblog