Trading Risk Management

This is one of the basic pillars of a profitable trading system. In trading terminology, the risk-reward ratio (RRR) is often used. For example, risking $10 to gain $20 is a ratio of 1:2. This indicator alone says almost nothing. We need to know other factors, such as the percentage of winning trades. Let’s say we backtested 3 months of data. We had a total of 100 trades: 70 were winners, and 30 were losing trades. Now, when we add an RRR of 1:2 with a risk of $10, is our system profitable? Let’s calculate.

Why gross? Because commissions and slippage would take another portion of this cake. Let’s say an additional 10%. Net profit could be around $99.

Position Sizing

When it comes to trading, one important question is: How many contracts can you trade? Generally, the recommended maximum risk per trade is 2% of your account, but this guideline may not be suitable for everyone.

Rethinking the 2% Rule

The 2% rule is a common recommendation in trading, suggesting that you should risk no more than 2% of your trading capital on a single trade. However, this fixed percentage might not be the best approach for all traders.

Considering Historical Data and Drawdowns

Let's consider a more personalized approach. Assume you have historical data of your trading strategy that shows your maximum account drawdown was 10%. Based on this information, you could decide to trade 2 contracts, which would potentially lead to a maximum drawdown of 20%.

Risk Tolerance and Personalization

Whether a 20% drawdown is acceptable depends on your risk tolerance and individual circumstances. It's important to tailor your risk management strategy to fit your own comfort level and trading goals.

Importance of a Large Data Sample

Instead of sticking to a fixed percentage per trade, it's crucial to analyze a large sample of your trading data. This analysis will provide insights into the maximum losing streak you can afford and help you determine a more appropriate risk management strategy.

By using a data-driven approach and considering your unique risk tolerance, you can make more informed decisions about the number of contracts to trade and manage your risk more effectively.