This week’s lesson we will be brief however it will cover an essential risk management concept.
If you are new to risk management concepts then understanding this lesson will allow you to objectively understand the strengths of your trading system, how and where you can improve your results, and gain an appreciation for how much risk you should be taking on.
There are 2 measures which all traders need to be tracking regardless of your chosen method or timeframe.
Those 2 measures are:
- Win percentage (W)
- Gain vs loss ratio (R)
The win percentage (W) is the probability that a trade will have a positive return.
W is calculated by taking the total number of winning trades and dividing it by the total number of trades.
For instance, let’s say you took 50 trades last year and 25 of those trades are winners, then your W would be 50% (25 / 50).
The win to loss ratio (R) is equal to your total trading profits divided by your total trading losses.
It is calculated by taking the total amount gained by winning trades and dividing it by total amount lost by losing trades.
So if your total profit last year was $27,500 and your total losses were $15,000 then your R would be 1.83 ($27,500 / $15,000).
As it pertains to risk management, using these 2 measures one can go on to calculate a ratio that is commonly tracked by traders and investors called the Kelly Criterion.
The formula for the Kelly percentage looks like this:
Kelly % = W – [(1 – W) / R]
- Kelly % = Kelly percentage
- W = Win percentage probability (total number of winning trades/total number of trades)
- R = Gain to loss ratio (total amount gained by winning trades/total amount lost by losing trades)
Many traders and investors use the Kelly Criterion as a guide to what percentage of their trading account is the maximum amount they should risk on any given trade.
Please note that you can only get a good idea of your system’s expectancy when you need to have gathered a large enough sample size to analyze. In order to really get a clear picture of the system’s expectancy, you should actually have somewhere between 100 and 200 trades.
Now to practical matters.
In the real world of investing or trading, there is always a constant balance between your W % and your R.
Often times traders will sacrifice potential returns to capture a high winning percentage.
Subsequently, many traders are often ok with a lower winning percentage if, in classic fashion, their winners are substantially greater than their losers.
Ultimately the way I like to best explain these 2 key measures is that –
- W is all about the quality of your trade ideas and how well you time them.
- and R is an expression of your ability as a trader to manage risk.
If your trading system suffers from a low W % then it is likely that you suffer from poor trade ideas and/or that your timing is poor.
To remediate this situation you will need to improve one or both of those 2 elements.
If your system’s R is low then this means that you are not doing a good enough job around risk management. This means either you are allowing your losers to be too large or that you are not letting your winners ride.
As a guideline, an R of around 2 or higher is a great score given a large enough # of trades.
And if you have a Kelly Score of 22 or above you and your system and performing very well.
In summary, this lesson introduced the 2 key measures which will serve as the basis for any further exploration into risk management.
I would highly recommend researching the Kelly Criterion further to better understand it’s pros and cons. Here’s a good place to begin.
To safely master the art of trading or investing, it’s best to learn and understand all of this material. It may seem complex at times, but I would encourage you to persevere. When you truly grasp it and work toward applying it in your trading, you will catapult your chances of real success in the markets.