From the March 2014 issue of Futures Magazine • Subscribe!

How to avoid blowups

Worth the risk

The second rule of managing your account prudently relates to risk management. Whereas money management ensures you always will have enough money to place another trade, risk management ensures that the trades you take are worth entering.

The rule is that you never enter a trade unless you stand to gain more than you stand to lose. I use a small amount of discretion as to the actual ratio of potential profit to potential loss, but in general, I look for opportunities to take twice my exposure out of a trade—with more being a bonus, and less being acceptable. While I consider my analysis an important part of my strategy, this rule vastly increases any given trade’s margin for error. 

You will find many descriptions of the benefits of this rule, but perhaps the most effective is a metaphorical one. Imagine you are at the start of a journey. Where you are, where you are going and how fast you get there do not matter. What matters is that you get from A to B. Now, imagine you have a coin with heads on one side and tails on the other. There are two rules. The first is if you flip the coin and it lands on heads, you can take two steps forward. The second is if it lands on tails, you take just one step back.

Assuming logic prevails, over a series of flips you should get an even distribution of heads and tails. This being the case, you will constantly move forward and eventually get to where you are going. Now imagine the reverse — heads you take one step forward and tails you take two steps back. Over a series of flips you will end up behind the point at which you started.

In real life, the steps represent your profits and losses. Even if you place random trades, if you gain more than you lose each time you do, over a series of trades your capital will grow.

The real beauty of this rule is it allows traders to lose on more trades than they win and still generate a profit over time. In fact, the market analysis needs only to be correct between 30% and 40% of the time. Consider the table to the right:

For the sake of simplicity, the examples maintained the same profit and loss on each trade with a 2:1 reward-to-risk ratio. Over a series of 10 hypothetical trades, four were profitable and six lost money. Despite this, and by following the risk management rule, the series of trades resulted in a net gain of $200. 

Despite the elegant simplicity of this rule, there is a caveat. By nature, the price of an asset in which you place a trade with a two-to-one reward-to-risk ratio must move twice as far in your favor to book a profit than it must move against you to register a loss. This shifts the odds against you and is why you cannot just place random trades and expect to gain. This is where the directional bias you form as a result of your analysis comes into play.

These two rules have allowed many traders to make a profession out of trading. For those with the discipline, these two rules might represent the “Holy Grail” that many traders spend their entire careers seeking. Unfortunately for them, they are searching in the realm of entry signals rather than risk management.

Samuel J. Rae is the author of Diary of a Currency Trader: A simple strategy for foreign exchange trading and how it is used in practice (Harriman House, December 2013).

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