Did anyone notice 3:1 reward to risk being metioned as important in the Market Wizards books? Ever wonder why 3:1? It's one of the basics taught to pro traders. Why? Because it allows you to use a position management technique that works like magic. Imagine you make two trades with 3:1 reward to risk on each trade. The first trade is a loser and the second a winner. In each case you buy 10 cars and use a 10 point stop. Trade 1 is a loser of 10*10 or -100 points Trade 2 is a winner of 10*30 or +300 points The net is +200 points and the profit to loss is 300:100 or 3:1. The second method uses a technique where you put on half the position. When the position is ahead by the amount of the stop you add the second half of the position and you move the stop on the first half to breakeven. With this you get: Trade 1 is a loser of 5*10 or -50 points Trade 2 is a winner of 5*30 or 150 points + 5 *20 or 100 points = 250 points. The net is +200 points and the profit to loss is 250:50 or 5:1 In reality it's not quite 5:1 but it is greater than 3:1 because some portion of the trades will be stopped out and end up as half contracts at breakeven and half with a loss. One really good thing it does is it allows you to trade at your largest size when you have a larger than average winner. It also cuts your drawdowns because you've reduced your risk on each trade by half. The idea is to "keep risk constant not the rewards". This along with "let your profits run and cut your losses short" are two of the keys pro's have used for years.
Yes, I've noticed it. It's mentioned in various guises by others, too. Even recently there was an informational-only site reviewed in a trade rag about the Original Turtle Method which can be downloaded free in PDF form here: http://www.originalturtles.org/system.htm The chapter on money management is a lot like method #2 that you described (although they keep adding contract sets based on ATR as the trend continues to develop, up to a fixed point). That said, the theory seems similar. Thanks very much for your clear, single-page distillation of an excellent money management technique.
hi acrary That's a nice idea, but I'm usually very reluctant to add to a trade once it has run my way though. I would add when it goes slightly against me, then scalp out the add and let the original run.. or run real fast when it goes even further against me. Am i backward? I like your saying of "keep risk constant, not rewards". That's a good money management tip, I have to remember that. Thanks.
I trade the ES and generally use a 2 pt initial stop-loss. So, should I be aiming to make 6 pts on every trade? Is that what you all do? -Fast
It all depends on your style. On some it is very difficult to take 6 points on a trade. The 3:1 is just a guideline, it would be great if you could pull 6+ on your winners.
Exactly. So, how can I apply this to trading ES? The way I see it, when I use a tight stop (1 pt), it has a higher probability/chance of getting hit. The larger 2-2.5 pt stop has a less chance of being hit, but when it does get hit, it results in a larger loss. I guess it's a give or take when it comes to risk/reward. Would appreciate some advice on this. -Fast
Fasttrader that would be exactly what you should be doing if your allowing yourself to take a 2 point stop loss. It may sound weird like 6 points is just too much and it may make you have to hold the ES all day sometimes and that may go against your mental makeup. (Not trying to insult you here). However that is what should be done. 6 points for a 2 point loss. If you were right on 50% of your trades then bamm your up : 6-2=4 points. So if you put on 20 of those trades a month, each 2 trades will be a win/loss combo at 50% win rate. That leaves your with 10 units all winning at 4 ES per net net total of 40 ES points. So if you play 5 ES at a time and do this strategy at 50.50 win loss ratio you would make 5*40 and make 200 ES points total for the month. 200 ES points * $50 bucks per point = $10,000 dollars for the month gross. This does not assume commission. assuming commission you would have been charged lets say at the IB rate of 2.40 per ES on a total turnover of 200 ES contracts for the month and a total commission of $480 bucks not bad only eating in to 5% of your gross for the month leaving you with $9,620 dollars. Thats not a bad take for the month at all in my book if you futures account has lets say 50K total capital in it. Not bad at all! Also your mind will be a much more at ease during the month if you keep your targets higher such as 6 points for 2 points because you wont have to tick f-ck the market all day. If you did half the trades and only did 10 of these opportunities per day your still going to make almost 60K gross a year after commission on a 50k account. Not bad at all. Heck you don't even need a 50k account to trade ES we all know that but I'm trying to be realistic in terms of have some equity cushion available for the mental aspect of the game. Take it easy.
Depends on where you enter. Half the daily range on the ES is a little above 5, so unless you're trading chop, you ought to be able to do that for half your trades (I have no idea what the expectancy is for scalping systems).
I think the most important thing is how much risk are you comfortable with. If you can stomach losses that are 6 pts then you have to be patient enough to take a 6pt winner and not take it off before it hits your target. Also, the 3:1 is only a guideline, some people shoot for about 75% winners, taking small losses and quick profits so you need to have more winners but this strategy may be more condusive with someone who has a lower tolerance for P&L swings..... I guess the whole point is that it is up to the indivdual trader what he is able to stomach and what his personality will let him/her take.