It's all about Risk
Trading is easy! I'll admit the act of trading is easy, but persevering through the ups and downs of the market isn't always so easy. In this article, I'd like to discuss some of the factors that characterize trading. I'll be specifically focusing on risk. No one likes to lose money, but losing in inevitable in trading, therefore the amount of *risk* we take is quite important.
If we could predict the market behavior, we could reduce our risk! Is it possible to predict the market? Maybe. If you had information about all the market participants, including the size of their accounts, and all their current positions, and knowledge of their decision making processes, and how consistently they do execute those process (which could be random), and a computer to take all that information into account in real time, with no software bugs. In other words, possible, but not probable. Given that we'll be working with woefully incomplete knowledge, what can we do? First, we can look at history. History will contain a sample of market events. It's important to note that this is only a sample, not the complete set of actions that any market is capable of. Just because a market hasn't done a certain thing, doesn't mean it can't. I'm sure you've seen the statement "past performance is no guarantee of future performance".
Given the information that we won't have enough facts to predict the market, it's virtually guaranteed that some executed trades will be losers in the financial sense. However, the amount you lose is up to you and is affected by two factors. Those factors are size and risk. If you buy 10 shares of a 50$ stock, you have a total risk of 500$ assuming you would watch the company go bankrupt and the stock goes to zero, like Enron did in 2001. If you decide to stop losing money when or if the stock reaches 40$, then you have reduced your risk to 100$ (without considering slippage and transaction fees). In this case, size is represented by how many shares you purchased (10) while risk is represented by how much loss per share you will accept before exiting the trade. Risk is defined on a per share basis, where as total risk is size multiplied by per share risk.
Let's work through an example. The figure below is a 1 minute chart of Crude futures on 2016-06-13 with times shown in Central Standard time.
Crude Oil Futures, Front month contract 2016-06-13, 1 minute
Let's further assume you decide to 'go long', that is profit from rising prices, when you start to see successive higher lows shown at points 1 and 2. It actually takes a few minutes past the point to detect it is a low. Point 2 occurs at 8:35 am and let's say you enter the market by 8:42 am at a price of 48.47. How much risk should you take
before you decide the market is not going where you'd like (remember long is up for profit)? Crude oil futures are traded inf 1 penny increments. Each penny represents a 10$ change to your account if you are in the trade. That means, if you are long, a movement of 10 cents up will change your by 100$ or a movement of 10 cents down, will subtract 100$ from your account. For this example, lets assume you are comfortable with a 200$ loss, therefore, you can set your stop (trade exit) at 48.27 (ignoring transaction fees and possible slippage). What is the minimum stop you could have had, and still have the trade be profitable for you? In this case, setting the stop any closer than 48.40 (the bar at 8:46 am has a low of 48.41) would result in the getting 'knocked out', that is your stop was activated and you exited the trade for a small loss before the market went your desired direction. Since you were comfortable with a 20 cent risk, how about the other side, reward? To give an answer, we need to introduce one more concept, expectancy.
Expectancy is the average win divided by the average loss, multiplied by the win rate in percentage, that is, how often do you make money vs lose money.
expectancy = (Win % x Average Win Size) – (Loss % x Average Loss Size)
This concept expresses is how much money you will be expected to make over a set of trades. Win rates vary per system. Some of the systems I've seen win about 33% of the time. If you only win 1/3 of the time, how do you make money? That means
the winners have to be much *bigger* than the losers. If your winners are 3 times as large as your losers, you'll be breaking even, which means you probably need a 4 to 1 ratio or higher to consistently make money. Applying this to the current trade, setting a stop at 20 cents, you will a reward 80 cents, or 49.27. As you can see on the chart, the market barely achieves this, and you would be so lucky to have gotten out at the top price of this chart! What if you set the stop (not shown) at 15 cents instead? Then a 4 to 1 ratio would be achieved with 60 cents or 49.07. Which do you think is more likely to happen, a 60 cent move or an 80 cent move?
Setting a stop too close will make your win to loss ratio worse, but the winners can
be smaller (and therefore more probable) and still achieve a high rate of return. A smaller winner will probably take less time, further reducing risk (less time in market) and possibly increase opportunity since you are out of the market quicker and ready to trade again. It's all about risk!! Questions, comments, thoughts?