Why Only 1% Capital Risk when Trading?

[mslk 10]

Hi,

 

Not sure what best forum is for this thread so I figured this forum would give it the most exposure (IMHO that, I think it deserves)

 

I have been researching various trading methods, for six months, that may or may not give me an edge in trading. I now want to move onto another part of my research. HOW NOT TO LOSE MY SHIRT.

I have often seen it mentioned that we should only risk at any time 1% or 2%( if your a high roller) of our trading capital at any time.

 

What I hope is that some members might enlighten me(and other newbies) with real experiences of what are the consequences of not listening to this rule. Also what are the real benefits of using a robust Money & Risk Management System.

 

Maybe also, what are some of the Physiological pitfalls that might be waiting to pounce.

 

Thanks

mslk

[BlowFish 10]

It's an OK rule of thumb but if you really want to understand how much to risk you want to look at RoR (Risk of Ruin). TradersCALM - Calculating risk of ruin explain it all fairly well, nice little freebie site focused on how really understanding RoR can free you from a lot of the negative feelings that can hamper effective trading.

[SIUYA 11]

there are some interesting articles here as well covering various money management ideas

Trading newsletter :: The Breakout Bulletin

[MadMarketScientist 11]

Most good systems can have 10 losers in a row, add in slippage etc you can easily see your

self down 12% (using 1% per trade), or 25% assuming you are using 2% per trade.

 

If you use 3%-5% then you could get drawdowns of between 30 and 50%.

 

A 10 or 20% drawdown does not require that much more effort to get back to breakeven but a

40%-50% drawdowns require a very high rate of return to get back to breakeven:

 

A 10% drawdown requires a 12% return to get back to breakeven.

A 20% drawdown requires 25%.

A 25% drawdown requires 33%.

A 33% drawdown requires 50%.

A 50% drawdown requires 100%.

 

Its unwise to risk more than 2% unless you have a system with small drawdowns (high win rate, giving

few losers in a row etc).

 

MMS

[BlowFish 10]

Most good systems can have 10 losers in a row,

 

It depends heavily on win loss ration and it is not a nice linear function either. Higher % approaches (even if the risk reward is only 1:1 or even worse) have much much smoother equity curves than those that have greater RR but lower probability.

 

The math is really easy so why not do it properly and have some confidence in the outcome?

 

Probability of 10 loosing trades in a row: P(10) = P(1)*P(2)*P(3)....P(10) if the probability for each event is the same this becomes (prob)^n where n is the number of consecutive same outcomes

 

So a 70% system would yield aprox .000006 chance of getting 10 losers in a row. (.3^10) or 6 in every million trades.

 

A 50% system yields aprox .001 chance of 10 in a row (,5^10) or 1 in every hundred trades.

 

I really don't understand why people 'wing it' and expect to have a good outcome, I find it staggering. It takes 10 minutes to do it properly so why not do so? People spend hundreds and thousands of hours on nonsense when it comes to trading but won't spend 10 minutes on the basics. Position sizing is one of the few things that you have absolute control over why guess at it?

 

Anyway OP I hope that this at least demonstrates that one size does not fit all. Just look at RoR, and make an informed decision or don't and hope for the best.

[TheNegotiator 13]

Here's a simple visual for you which explains that as you risk a smaller %, your number of losing trades in a row before account ruin increases exponentially.

[pbylina 10]

If you loose 3 times in a row you should take a break.