The most successful traders don’t see themselves as traders, but as risk managers; professionals understand that protecting what they have is the key to long-term success in trading. In the following article we explore what risk means for traders, how you can get a better understanding of it and how to manage risk effectively.
What is risk?
In its official meaning, risk describes the potential of losing something of value. Traders often talk about risk as ‘the cost of doing business’, which is a very shallow way of looking at it and does not fully capture the whole meaning of risk in trading. It is true that upon entering a trade, you are risking a certain amount; the distance of your stop loss order, in combination with your position size defines the worst-case scenario. However, it goes much further and risk is a very complex concept in trading that can be controlled and managed very accurately.
3 probability concepts that cause traders to lose money
To understand how trading performance is influenced and what causes wins, losses and streaks, it is important to understand the three following probability and risk concepts.
Randomness of results
Although research does not fully agree whether stock returns follow a random walk or not, it comes close enough to assume that returns are independent. This means that the outcome of your current trade does not provide information about your next trade; having a winning trade does not mean that your next trade has a higher chance of winning (or losing). The same applies to playing dice; if the dice shows a ‘6’, rolling another 6 is just as likely as seeing any of the other numbers.
Traders who are on a winning streak should not overestimate their abilities and should not increase their risk because the streak could end with the next trade already. On the other hand, traders who are in a losing streak should not increase their position size either with the belief that the chances of finally winning a trade are rising.
You cannot control the outcome of your trades. Even if you see a textbook signal, it usually has the same probability of failing as other entries. Traders who overestimate the quality of a trade are more likely to hold on to losing trades because they believe that an “above average” setup cannot fail. Upon entering a trade you CANNOT know whether a trade will be a winner or a loser. Do not risk an inappropriate amount of money on a single trade because you believe the setup is “too good to fail”; getting married to a trade can result in a costly divorce.
The law of large numbers does not save you
Although the law of large numbers indicates that over the long-term, the distribution between winners and losers is fairly accurate – with a winrate of 65%, you should see 65 winners and 35 losers over the course of 100 trades – there is no guarantee that the distribution will always follow the statistics in the short-term.
Objectively judge your performance, evaluate whether you have executed your trades ideal and focus on being the best trader that you can be and start thinking in the process-oriented mindset. Eventually, the odds will move in your favor with the help of statistics and adequate risk management. If you respect the connection between the risk reward ratio and winrate, and have a positive expectancy, you will be fine eventually.
Personal level of risk
Although you can frequently read about specific risk suggestions such as “never risk more than 1% of your capital on any single trade”, there is more to position sizing than just picking an arbitrary amount and applying it to any single trade.
Winrate – Adjusting position size for your level of risk tolerance
The winrate of your strategy has a direct impact on the optimal size of your position. The lower your winrate, the more frequently losing trades you will have and the higher your drawdowns will be.
How well can you handle drawdowns? Whereas some traders are unaffected by losing a significant amount of money and can still trade at a high performance level, some traders get distracted easily and start making emotionally caused trading mistakes. If you belong to the latter group, you should think about adjusting your position size based on your winrate and how you well can handle drawdowns.
Just think about it with a very basic example: over the course of 200 trades, the statistical difference between a trading strategy with a winrate of 50% and one with 60% will be roughly 20 losing trades (100 losing trades with a 50% winrate and 80 losing trades with 60% winrate). If you use a 1% position size on both strategies, you will see a (roughly) 20% higher drawdown on the strategy with a 50% winrate. Amateur traders, especially are not good at handling drawdowns and the higher the drawdown, the more frequent impulsive trading mistakes will be. Adjusting your position size based on your winrate can prevent unnecessary trading mistakes.
Risk and performance simulations
The following video illustrates the point further. We simulated different risk scenarios for trading strategies with different winrates and position sizing approaches. The risk simulator uses personal inputs and then performs a random simulation over 200 trades.
Basic understanding: The different output curves represent possible scenarios for performance developments over time. The further apart the individual curves, the more unstable and volatile account swings and outcomes will usually be.
The video and the simulation show how winrate and position size should be put in context together to fine-tune your trading strategy and to avoid emotionally caused problems.
While talking about position size and drawdowns, it is important to talk about the level of capitalization as well. The reason why traders use position sizes that are too big is because their trading accounts are too small. A 1% position size on a $1,000 account does not lead to meaningful results and, therefore, traders use an inappropriate position sizing approach which leads to impulsive trading decisions and huge drawdowns.
Conclusion: The overlooked connection between winrate and position size
The winrate of your system is not as easy to manipulate, but it significantly affects your trading performance, the occurrence of losing streaks and the size of drawdowns. Together with your position sizing approach, you can very accurately determine the level of risk you are willing to take. Therefore, you can self-determined manipulate the expectancy of your trading system and control the outcome for your account growth and the level of risk you want to take.
Read more about risk preferences, individual risk levels and how to control risk in part 2 of this article.