Risk & Reward
Did you know that the majority of traders win more than 50% of their trades, some even more than 70%? Nevertheless most traders aren't profitable at all. At the same time casinos manage to build a profitable business in a 50/50 chance game. How is it possible?
Why do most traders fail despite positive win rates? The answer can be found in human psychology. How do we tame the inner beast? By managing risk properly.
This post is a brief introduction to the concept of risk management in trading. It is intended to provide insight to help you avoid the common pitfalls that have prevented traders the majority of traders from being profitable in the long run.
Many experienced traders say that profitable trading is not only about finding the best trades, but also about proper Risk Management. Some even go so far to say that profitable trading is only about Risk Management. Some even call it the holy grail.
In my experience, you can't be a good trader without a proper RIsk Management.
Let's start with the most used risk management terms:
- Entry = price at which your order is executed
- Position Size = number of coins you buy or sell
- Capital = your total account balance
- Stop Loss = order to close a losing position and prevent further losses
- Risk Amount = Capital you lose in a trade if your stop loss gets hit. If you want to maximum risk 1% of your capital in a trade, this is 0.01 x Capital amount.
Often new traders overestimate the importance of their trading methos at the expense of risk management. But your trading method can only bring you so far. As we know the market can do anything at any time. There is always the possibility of a news event we couldn't predict at all. No trading method can guarantee a 100% win-rate. That's why proper risk management is just as important.
Traders use stop-loss (SL) orders to exit their position when price hits a level "where the market has turned against them". SL orders help you keep your losses small. It has to be at that technical level where the reason you entered the trade is no longer valid. When entering a trade, you determine your SL location using technical analysis, like moving averages or support and resistance levels.
What is most important is that when you enter a trade, you do it for a reason. Because you saw a particular price pattern. When price action turns out to behave differently, then your reasoning to be in the trade has lost its validity. So:
When price violates the exact reason you entered the trade, is the signal to exit the trade.
Many traders use a sof SL, they first wait for price to violate the reason to be in that trade, before they place the stop order manually. I prefer to use a hard SL to determine in advance at what price the original reason to enter the trade will be violated, where you will be proven wrong, and at what price you place a SL order as soon as you enter the position.
Some traders dislike using SL mainly because although it protects you against very big losses, it can also stopotherwise profitable trades too early.
Many research papers prove that stop losses actually work:
https://www.lunduniversity.lu.se/lup/publication/1474565
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2407199
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=968338
At any time, you should be aware of possible stop-hunts/ fake-outs.
Often many (mostly retail) traders get stopped out, because they think a support is a very narrow price level, and thus put their stop loss orders right below it. Big traders often use this knowledge to stop out retails traders to get the liquidity they need. This is called stop hunting. And the fake break-outs of those supports (and resistances) are called fake-outs or failure swings. That's why you should always use higher timeframes on major swing highs and lows, to confirm that it is actually a real break-out. So always look for confirmation with an actual close above/below the support or resistance level on a higher timeframe chart.
Supports and resistances are the cornerstones of all chart patterns. Most of the time supports and resistances are not exact lines, but more like zones. So even though people draw people draw them as lines, you better treat them as zones. Not everybody draws their lines at the same spot. And traders don't place their bids and asks at the same spot either. It's a typical beginner's mistake to look at s/r levels as precise lines.
Risk management actually refers to a wide range of different things. Let's start with position size. Risk management and position sizing go hand in hand. Most novice traders trade with the same size in every trade they make.This eventually results in risking too much on your total account in a wrong trade, and wiping out many previous winning trades.
That's why we need to practice Money Management. We need to manage our total trading capital. Proper money management means:
Only risking a fixed percentage (of your total account) in each trade. Most professional traders only risk a maximum of 1.5% to 3% of their total capital.
Your risk (the money you could lose) in a trade is determined by where you place your stop loss. Let me explain by an example:
- Total account capital is $ 1000
- Max allowed risk amount per trade is 1.5% of capital. 0.015 x $ 1000 = 15
- Position size : 10 coins at $ 10 = $ 100
- Stop loss distance not further than: ($ 100 - $ 15) / 10 coins = $ 8.5
As you see, position size, total capital, and stop loss are all tightly connected. When you decrease the distance to the stop loss, then your allowed position size increases. Thus a tighter stop loss, gives you a bigger position size for the same risk amount. All this is to ensure that you never exceed the maximum allowed risk over your total capital in a single trade.
- First determine the SL level based on TA
- Next determine your position size: how many coins you can buy, based upon your total capital and the maximum allowed risk %
- Coin price on entry: $ 10
- TA based stop loss level = $ 8
- Total account capital = $ 1000
- Max allowed risk per trade: 0.015 x $ 1000 = 15
What is the max allowed position size?
- $ 10 - $ 8 = $ 2 risk per coin
- $ 15 / $ 2 = 7.5 coins or $ 15 / 0.2 (risk % in decimals) = $ 75
- (if 7.5 coins hit SL, then the total loss is $ 15
This leads us to the following position size formula:
Nr of coins = (max allowed % risk per trade x capital) / (entry - stop loss)
Practice this a lot, for a pro trader this should be second nature. You can practice this by answering this question when planning a trade:
- What is my total account capital? $ 1000
- What % of my account do I want to risk? 2% ($ 1000 x 0.02 = $ 20)
- What is my entry price? $ 10
- What is my stop loss price? $ 8
- What is my position size? $ 20/ $ 2 = 10 coins
Margin and leveraged trading allow you to borrow cryptocurrency with your trading capital as collateral.
You don't use your capital to trade crypto directly, but indirectly. You use your capital to borrow more cryptocurrency. So you can enter a bigger position with les money. This is called leveraged trading.
"Liquidation" happens when the losses on your position exceed the capital you used as collateral to borrow that position.
That's why you lose that capital on liquidation. So when you use ALL of your capital as collateral, then you also lose all of your capital on liquidation.
If you want to make sense of leveraged trading, then your allowed position size is indispensable information. Leveraged trading can increase your potential profit, but can also increase your losses at the same time. Thus, it influences your maximum allowed position size. Proper risk management is essential.
- What is my total account capitel? $ 100000.
- What % of my account so I want to risk? 2%. (100000 x 0.02 = $ 2000
- What is my entry price? $ 10000
- What is my stop loss price? $ 9000
- What is my position size? $ 2000/ $ 1000 = 2 BTC
Now imagine I use 2x leverage instead. When price hits my stop loss now, I lose $ 2000 (instead of 1000). Thus my max allowed position size is now $ 2000/ $ 2000 = 1 BTC
How much leverage should you use max? Please read the following on binance website: "On average, over 80% of traders use on binance futures trade at a levergae of 20x or higher (chart below). Additionaly, 20% of the users trade with 100x or more leverage. While high leverage trading is most popular among binance futures retail traders, most of its institutional traders, who contribute to 81% of the total trading volume, tend to trade at a leverage of 20x or less".
So 80% of binance futures traders use 20x or higher. These are the majority of traders, retail traders. But the biggest traded volume, 81% of total trading volume , or the institutional traders, tend to trade at 20x or less.
A 30-day average of leverage usages on binance futures:
As we will see later on, the majority of traders is not profitable in the long run. Eventually retail loses, and big money wins. It's obvious we should avoid retail behavior, like using high risk leverage, and stick to the sub 20x/10x levels instead.
For a professional trader it is very important to remember, maybe even repeat like a mantra, this quote from Warren Buffet:
"Anything can happen anytime in the markets."
The crypto market is a very volatile market, and as such can be compared to a casino. Many unexperienced novice crypto traders are high on "hopium", and their trading career is a mere gamble. They "fomo" into trades only to panic out of them next.
The reason many new traders blow up their accounts is because bad risk-reward (RR) ratios combined with losing streaks. They take big risks for small rewards and to repair that damage they take even bigger risks. But for every percentage that you lose, you need an even bigger percentage to recover, like illustrated below:
So if you lost 50% of your account in the last trade, you need a reward of 100% in the next trade to only break-even. And you even need a reward 9 times bigger if you lost 90% in the previous trade.
Besides a healthy RR ratio, you should obviously never risk too large a portion of your account in a single trade.
But how do professional traders stay in the game in such an unpredictable market? Just like how a casino stays in the game. For example many people think that the roulette is a 50/50 game.
But in reality, the casino has a small advantage. The roulette wheel has 18 red numbers, 18 black numbers, BUT also 2 green numbers. Anytime it hits the green numbers the casino wins. It is not a 50/50 game ay all, the casino has a small advantage. Out of the 38 numbers, the player can win by 18 numbers, the casino by 20 numbers:
This shows you the casino has a 5.3% advantage over the player. This shows us that the casinos are in this for the long run. They don't mind losing bets, because in the long run they win the most bets.
This is exactly what professional traders know. Next to having high win-rate trading methods, they a re used to manage risks like casinos.
Traders shouldn't base their SL (and take profit) on a fixed risk/reward ratio, but use technical reasons to decide where to take profit or to take a loss. But you can use a 1:1 RR ratio as bottom line. So for every $1 you risk, you want to win at least $1. It's good to avoid trades where you can potentially win less than you can lose. Many Many traders actually prefer a RR ratio between 1:1 and 1:2 (or higher).
This is popular trading rule. Big wins & Small losses = Profitability
Experienced traders know this, keep your losses small, and let your winners run. This has to do with statistics, as illustrated in this graph.
As you can see, the higher the RR ratio, the lower the required win rate to break-even! For example when RR ratio is 9, then you are break-even after winning only 10% of your trades. So, when you win 50% of your trades, that means 40% is pure profit. Imagine if you win 70% of your trades with such a RR ratio. The next table shows you some exact numbers.
This is very important to grasp:
Imagine you take very much risk for very small potential profit, a RR of 50:1. Then you need to win 98% of your trades to only break-even. But imagine having a high probability strategy and win 5% of your trades while risking 1%. Then you would be break-even after 17% of your trades being winners. If you lost 83% of your trades you would still break-even.
Statistics let you win in the long run. Even with a low win-rate. Don't focus too much on single, but look at trades as part of a series of trades. Don' get scared of losing trades but keep them small. In the short term you might have a losing streak, but in the long term you will win, because of your statistical advantage.
The higher the risk/reward ratio you chose, the less often you need to correctly predict market direction in order to make money trading.
Unhealthy risk-reward ratio's, and holding on to losses is a psychological pehenomenom. Most traders have a tendency to avoid losses at all costs. This is also known as "lossaversion theory, or Prospect Theory." It means that losses tend to have a bigger impact on traders (and people in general), than an equal amount of gain does. When an average trader wins $1000, this leads to less emotional impact, than when it would have been a $1000 loss. That's the reason many traders hold on their losing trades, and turning them into big losses, as they can't accept the loss. This obviously creates an unhealthy risk-reward ratio.
How prospect theory works is illustrated in the next matrix:
There are 2 instances where we exit a trade. When we take profit (TP) or when we stop loss (SL). But how do you know it's time to exit your trade? You already learned a popular trading rule: Big wins and small losses = Profitability.
We can learn a lot from the forex market, as this market consists of many experienced traders. A major forex broker shows us these results:
"The above chart shows the results of a data set of over 12 million real trades conducted by clients from a major FX broker worldwide in 2010 and 2009. It shows the 15 most popular currency pairs that clients trade. The blue bar shows the percentage of trades that ended with a profit to the client. Red shows the percentage of trades that ended in loss".
As you can see, traders are correct more than 50% of the time, with the most papular currency pairs. So, you would think that most traders would be profitable trading Forex, right? But it's nope. Most Forex traders are actually not profitable.
to understand why, please take a look at the next chart:
"The above chart says it all. In blue, it shows the average number of pips traders earned on profitable trades. In red, it shows the average pips lost in losing trades. We can now clearly see why traders lose money despite being right more than half the time. They lose money on their losing trades than they make on their winning trades".
Many forex traders that are wrong about the market's direction, are still profitable in their overall trading. How? Because they practice good money management; they cut their losses asap and let the profit run.
The importance of money management and thus the usage of stop loss and take profit orders, is illustrated in the following chart:
"The 2 lines in the chart above show the hypothetical returns from a basic RSI trading strategy on USD/CHF using a 60mn chart. This system was developped to mimic the strategy followed by a large number of live clients, who tend to be range traders. The blue line shows the "raw" returns, if we run the system without stops or limits. The red line shows the results if we use stops and limits. The improved results are plain to see."
As said, it is normal for humans to want to hold on to losses and take profits early. It is the main reason many traders fail to be successful. We must overcome this, and remove our emotions from trading.
The best way to do this is to set up your trade with stop loss and take profits orders from the beginning, and stick to your plan. Once you set them don't touch them again.
You need to know when you are in a losing trade. As a technical analyst you should already know at which point your trade goes wrong, even before you enter the trade. The technical reason why we enter a trade always has a level where it is no longer valid.
Many new traders built their strategy upon their entries. But it is just as important to focus on your exits. You need an exit when you are right and when you are wrong. When you go long and price goes up, then you are ok, the trade will often take care of itself as it runs towards your take profit target. But in case a trade turns against you, you should also know where your stop loss target is. That's at the price level where technical analysis is proven wrong. It's the level where you no longer want to be in the trade. It can be because analysis were wrong or the market changed direction, because remember:
Anything can happen at anytime in the markets.
In the previous part you already learned how to manage your risk using position sizing. That is set in advance, before entering the trade. Now you know you should also determine the level where you cut your losses in advance.
Now afteryou have entered the trade you can actually sit back, relax, and let the trade plays out. This is also very healthy from a psychological perspective.
You need to do your own analysis, plan the trade, follow the plan, and manage risk. No one is forcing you you to get on a trade. Take you own responsibility. And remember. You will get losing trades. Don't try to avoid losses, or you might losing all.
Don't trade with fixed SL or TP percentages. Don't force your static SL/TP level on the markets but let the market decide where they should be. Use technical analysis for this. There are no magic numbers for this, no holy grail.
Many FFT strategies result in high win rates. When trading high win rates signals and back testing different settings, you will notice that when you improve your risk/reward rate (by setting a correct SL and TP), then your win rate will deteriorate proportionally.
Risk/reward and win rate are actually 2 sides of the same coin. A too close SL will hit more often statistically. Give trades less room to breathe, ans the more trades will die.
Many traders claim the holy grail in trading is to have a high win rate; while having a high risk/reward at the same time.
In my experience the most important habits of professional traders is the avoidance of over-trading. After finding the high win rate opportunities with the highest probabilities (like FFT signals) professional traders only trade those setups with the healthiest risk/reward ratios. This is the most reliable path to the "expert trading" quadrant in the above matrix.
To less experienced traders these habits are sufficient to be profitable
- Get an edge over the market, so you win more than 50% of your trades. This can be achieved by a solid trading system, for example based upon FFT signals ans strategies. (Although I know there are many expert traders that are even profitable with a 30% or lower win rate).
- Your risk/reward ratio should remain above 1. The higher the better but keep an eye on your win rate.
- Don't over trade, let the market decide. Be patient, a profitable trader knows also when to stay out of the market.
A popular entry method amongst some traders is to average into positionsusing additional entries as price move against their first entry. This is often considered a bad practice by many other traders though. This technique is called "adding to a loser". But let me explain why I don't totally agree. There should be a logical and technical reason to double down on position. By looking for divergence on (multiple) momentum indicators, like the rsi and MACD (and histogram). For example, when price breaks below your entry level, and makes a lower low, this could be considered a reason to cut losses and exit the trade. But you could also consider adding to your position, in case you get a good signal, or the momentum is decreasing and the price might still reverse soon. Although price action goes against us, decreasing momentum can be a sound technical reason to stay in the trade and even add to it. In my opinion this helps me with one of the hardest part on trading: timing your entries right.
Example of a double bottom signal, where adding to the position at the lower low is justified by MACD (and histogram) divergence indicating the decrease in bearish momentum:
An important question when averaging into a position is:
When do you stop adding to a position and decide stop your loss?
Just like we determine our stop loss based on technical analysis that give us the levelwhere the reason to be in the trade is no longer valid, determining if we want to increase the position is also based on technical analysis.
If price goes against us, beyond our initial entry, but momentum shows divergence, this confirms a possible reversal, and we can decide to add to our position, and improve our exposure, and average entry price.
But on the contrary, if price goes beyond our initial entry , but momentum is convergent as it also continue to increase, and our reason to enter the trade in the first place is weakening, then we might consider to skip another entry, and wait for price to choose direction: reverse or continue and hit our stop loss. It's always best to let the market decide.
In trades with high profit potential, you can consider using a "zero risk" approach:
- Set your RR at 1:1, so the SL at the same distance than the TP.
- When price hits the TP level you exit only 50% of the position.
In case price fails to go any higher and falls back to the SL level, then you close the remaining part, and the whole position is closed at break even, or "zero risk". But in case the price does go higher, you have infinite profits potential. After the first 50% exit, without moving the stop loss order, the risk is limited to zero, and you get unlimited profit potential. Knowing how to maximize profit, while taking the fear out of a trade is one of the most powerful asset a trader can have.
Of course this zero risk strategy can only be executed when the market reaches the 1:1 TP level first. In case it first reaches the SL, then you can't turn it into a zero risk trade obviously.
Simple zero risk rule: If you use a 1:1 RR and are able to exit the first 50% of your position at the TP level, then the rest of the trade is risk free.
You should never move your SL to break even though. Then the SL level no longer makes sense from the perspective of the technical reason you entered the trade in the first place. When placing a SL you should consider volatility, a trade needs room to breathe, if you take this away you could potentially close a winning trade too early.
This turns the odds against you in the long run. The ATR valueis often added as extra volatility buffer to the stop loss distance.
The information on this resource is addressed to an unlimited circle of persons, and is not an individual recommendation; It is exclusively informational and analytical in nature for our team own use, and should not be considered as a proposal or recommendation for the investment, purchase, sale of any asset, trading operations on financial instruments. It's your own responsibility what usage you will make about it. The views expressed reflect only the author’s exclusively personal view.
To join or have a look at the channel with a 30 mn trial, follow the provided link to our chatbot @JoinFFTChannelVIPbot (Telegram)