Trading is a Statistical Business Risk Management

TRADING IS A STATISTICAL BUSINESS-RISK MANAGEMENT

The probability of a winning trade not only provides insight into whether a trading pattern is worth using, it also provides insight into position sizing and money management strategies. In the coin flip example, few people would want to bet their entire account on each trade because to come out ahead, they would need to win every coin flip. The more times the coin is flipped, the more likely it becomes they would lose their entire account. The same is true for trading.

If a trading pattern has a 50% chance of producing a winning trade, then the likelihood of eight losing trades in a row is one in 256. These seem like good odds against losing eight times in a row, unless you also consider how many trades the trader makes in a year. If the trader makes 50 trades a year, the trader is unlikely to see eight losing trades in a row and might consider risking 1/8 of the account on each trade. If another trader makes five trades a week, the odds are quite good that sometime during the year, he will see eight losing trades in a row. If the second trader risks 1/8 of the account on each trade, he has a good chance of going broke at some point during the year.

The amount risked on each trade should be a function of the probability of a winning trade, the number of trades made during the year, and the maximum drawdown the trader is willing to accept. Each trader has a different tolerance for risk. Some are bothered by a 10% drawdown in their account. Others do not lose sleep when experiencing a 30% drawdown. In this example, if each trader makes about 200 trades a year (and thus has a reasonable chance of seeing eight losing trades in a row), the first trader should risk less than 10% of his or her account divided by eight on each trade. The second trader should risk less than 30% of the account divided by eight.

The amount of risk, or maximum drawdown, a trader is willing to take divided by the maximum number of expected losses (which is a function of the number of trades made) is a starting point for considering the amount to risk on each trade. There are no guarantees in trading, but understanding how the winning percentage of the trading pattern and the number of trades affects overall risk is an important place to start when looking at risk management.

New traders often do not understand the risks they are taking and will blame drawdowns on bad luck, and then credit profits with their expertise at picking good trades. But always remember, trading is a statistical business. There is no magic indicator that will tell you which trades will work and which will not, no matter what those slick brochures say. Traders must understand the probabilities involved and how to use them to manage risk. The backtesting results are one way to gather some of this information.

Imagine 16 traders all using a trading pattern that wins half the time and yields 10% on each winning trade. If they all make a trade, we could expect eight traders to have winning trades with their accounts up 10%, and eight traders to have losing trades with their accounts down 10%. After the second trade, four traders would have winning trades both times and be up 20%. After four trades, there would be typically one trader who was up 40% and one who was down 40%.

The trader up 40% may be invited to speak on one of the financial programs “because he knows how to pick winners.” The one down 40% would “just know” that the trading pattern did not work and may move on to another technique in an endless search for something better. Most of the traders would have results in the middle. Trading patterns that have winning trades more than 50% of the time and larger average wins than average losses move the odds significantly in the trader’s advantage. Making actual trades is the easy part of trading; most of the work goes into researching and carefully understanding how a trading pattern performs.

Traders want to use trading patterns that have winning percentages well above 50% because it stacks the odds in their favor. They also want the average winner to yield more than the average loser costs them. When these two conditions are met, the trader knows that the inevitable winning streaks should gain more than the inevitable losing streaks lose, and also the winning streaks should happen more often than the losing streaks. It is this knowledge that makes trading worthwhile. As is true with every business, knowledge is one of the keys to success in trading.

Trading without this knowledge exposes you to unknown risks. Traders with a clear understanding of how different trading patterns perform are willing to take known risks for expected gains. There is a connection between the level of risk assumed and the expected returns. Lower risks can be easier to tolerate, but often result in lower returns. Higher risks expose the trader to larger drawdowns, and potentially larger gains. Each trader needs to find the risk/reward scenario that is most comfortable for them.