This element of your trading plan is a category of specialized trading rules to help you identify HOW MUCH money to put into any given trade. This seems like an easy thing to implement but it can get tricky as you enter and exit equities at different price points over time. We’ll get address this topic throughout your curriculum because of the critical nature of these rules. Your system will lose value if you fall into the trap of risking different dollar amounts on your trades.
These rules will also help you identify your trading objectives—how much you hope to gain compared to how much you are willing to risk (and even lose) over the short term.
The two rules in this category that you must fully articulate in your trading plan are:
You should think about these rules and complete your trading plan with the values you have selected. Each of these rules will be described in further detail.
Remember, your trade plan is a living document which you change and adapt as markets shift and as you gain more experience and confidence. So articulate your angle of approach as best you can for now and then begin paper trading for a while to see if you need to make any changes to your trade rules before you start trading with real money.
Remember, your success is over time is predicated on your ability to follow your rules on every trade, not on the outcome of any one (or even a series) of individual trades. So set some rules and the paper trade them exactly. Then revise your rules as you see things you can do to improve your trade outcomes. Then iterate over and over until you have a set of rules you trust to profitably guide your market activities.
Risk Management Rule 1: My Profit Objectives
Every trader would like to make an unlimited amount of money in as short a period of time as possible. But that unrealistic and non-specific goal isn’t helpful for successful trading. Instead, decide how much you would like to make over a given year, quarter, or month, or other time period of your choosing. The easiest way to think about this goal is to start with the amount you’d like to limit your losses to. This is referred to as your drawdown. You should specify the annual amount of drawdown you are willing to endure.
For example, if you are willing to risk losing 10% of your account in a year, then you know a realistic profit target is 20% for that year. A simple rule of thumb for beginners is to target making twice as much as your worst-case drawdown over an annual period. As you gain real market experience in the markets and find ways to improve and be more confident in (and therefor follow more exactly) your trading system, your trading edge should improve helping you increase the amount you gain without a corresponding rise in risk.[/vc_column_text][vc_single_image media=”1587″ media_width_percent=”75″ alignment=”center”][vc_column_text text_lead=”yes”]Profit objectives can be boiled down into just one number known as your Expectancy which measures your average net gain (or loss) over all your trades. Knowing your expectancy and watching it move up and down over time is a simple way to identify three things:
Understanding how to combine your wins and losses into an expectancy number gives you a simple way to gauge the temperature of your system. Any changes in this number gives you good reason to take a deeper look at you, the markets, or your system and helps you maintain good trading techniques that adapt to current market conditions over time. Keeping your expectancy above a set amount (as discussed in Lesson 6) will improve the consistency of your profits and results.
Understanding your system’s expectancy helps you forecast profit objectives. The Rules of Thumb numbers for determining expectancy are:
These numbers can be plugged into an equation which multiplies Targeted Gain (G) by Trade Frequency (TF) and Trade Risk (TR) together to arrive at an Expectancy (E).
G x TF x TR = E
Let’s say you decide to target an annual gain of 20%, that your system and time available to trade is to make 100 trades a year (2 trades per week) and that you will only risk 1% of your overall portfolio on any one trade.
In this case the formula would be (20%) x (100) x (1%) = an expectancy of .2
But what if we increased our per trade risk to 2%? The formula would be 20% x 100 x 2% = a .4 expectancy.
The power of this equation is that you can change these numbers to better fit your trading style or the strategy you use. For example a lower expectancy can be offset by a greater trading frequency. It might be helpful to run different numbers through this formula. If you have additional questions, be sure to ask them in class.
Knowing your expectancy and expected account growth helps you focus on following your system exactly even during possible losing streaks as you keep your eye on variables you can control while also using it as a measurement to help you find areas in your process you can improve. Using this formula to inform your trading helps you maintain your methodical approach to the markets and avoid emotional responses to individual trade outcomes. It also helps you carefully and logically react to changes in the markets as they arise.
Risk Management Rule 2: Limiting my Drawdown
Trading or investing is filled with probabilities and expectations. You cannot hope to win every trade. Nor should you assume a “buy; hope, wish and pray” gambling approach. Because most people don’t understand market probabilities and either don’t have or can’t follow their system, they struggle to feel confident or to maximize their results over time. Understanding the probabilities associated with your natural trading style and working to improve your results by learning tactics to improve your trading edge builds your confidence and allows you to maximize your profits over time.
Knowing your Natural Trading Style gives you a clearer idea of both trade frequency and potential winning and losing streaks you’ll likely experience at some point. (This will be discussed in detail in the Trade Execution Rules section.) Knowing your natural trading style’s base winning percentage and learning ways to improve your trading edge and trade expectancy helps you reduce the frequency and negative impact of losing streaks. Reducing your losses automatically increases your gains and improves your expectancy. To clarify this concept, let’s use Just Win’s natural trading style’s expected base winning percentage and longest losing streaks:
Identifying these amounts now makes it clear how much you can risk on each trade. For example in this case, if you only risk 1% of your entire portfolio per trade, then your worst losing streak would only create an 10% drawdown in your account. If you are willing to risk 20%, then you could afford to risk 2% per trade.
We recommend starting out by risking a smaller percentage(say 1%) until you have more confidence in yourself and in your system.
The tradeoff to this approach is that by protecting yourself from losses, you also limit your upside. But that’s okay because initially it’s about becoming familiar with this systematic approach to the markets and confident in your ability to make consistent profits. Once you feel confident and have some success, adjust your rule to allow for a higher max drawdown and increased risk per trade.[/vc_column_text][/vc_column][/vc_row]