The next big component of a trading system is determining how much to risk on each trade. This is probably the most important aspect of a trading system. The point is that you are always going to be right on some trades and wrong on others. The idea is to make the numbers work out in a way so that you will make more money on your winners than you will lose on your losers.The fi rst component is to determine trade size so that you don’t have a single trade that will wipe out your entire account or, even worse, your life savings.
The fi rst question that you have to ask yourself is: How much am I willing to risk on any one single trade? There is a risk management principle referred to as the 2 percent rule. And this is basically a rule of thumb stating that you should not exceed a loss of over 2 percent of your account balance on any one single trade.
For example, if you have a $10,000 account, you should not lose more than 2 percent of that account ($200) on any one single trade.The 2 percent rule is a great rule of thumb to use; however, the numbers should vary a bit. They should be anywhere from 1 to 5 percent, depending on how many consecutive losing trades your entry and exit condition produced historically.
THE PROCESS:Here is how the process works:The first thing you need to do is to check how many consecutive losing trades your system can have in a row and how much dollar/point profit you are going for on each trade. If your system historically has had a fairly large number of losing trades in a row, then you want to make sure that the most that you risk on the trade is 2 percent or less.
If the system historically has not had a large number of losing trades in a row, then you may want to risk slightly more than 2 percent.Consecutive losses are what will get you here. They will create what is known as a drawdown. A drawdown is a dip in the equity curve of your trading account from the net new equity high. For example, let’s assume that your account starts out at $10,000 and then grows to $25,000 until you hit a series of losing trades. Let’s say you have a bunch of losing trades in a row and your account value falls to $15,000.
Your account will be in the drawdown until it breaks the previous equity high of $25,000.Your strategy will always cause your account to go into drawdowns simply because some trades will go against you. It is important to know how to handle these drawdowns, and this will be covered more in the account/money management section. The idea is that you want your losses small enough so that the drawdowns stay relatively small.
As a rule of thumb, most good trading systems have drawdowns of under 20 percent.Keeping this in mind, you can now look at your consecutive losing trades and plug in account percentage levels to each trade to see what the total drawdown will be based on how much you risk. For example, if you risk 2 percent of your account on each trade and you have a total of five consecutive losing trades, your total drawdown would be slightly less than 10 percent. Here is how it would be calculated:Let’s assume that you are trading a $10,000 account.
The balance is really arbitrary; it is simply used here to illustrate an example.Exhibit 14.1 shows the numerical and percentage‐based breakdown of what a 10 percent drawdown on a $10,000 account would look like on five 2 percent losses.As you can see, if you take a 2 percent loss on each of the trades, then your total loss from your initial balance will be slightly under 10 percent if you hit five consecutive losses.
If using the same example you risked 5 percent on each trade, then your drawdown would be much bigger. See Exhibit 14.2.Exhibit 14.2 shows the numerical and percentage‐based breakdown of what a 20 percent drawdown on a $10,000 account would look like on five 5 percent losses.Using this simple table calculation, you can play around with the historic results or back‐test of your trading system to determine how much to risk on each trade.
If you don’t have any historic results for your trading system, nor have you back‐tested it, then it is best to stick to the rule of thumb of 2 percent as you initiate your test and work with the numbers from there. Going over a 5 percent maximum loss risk on any trade is not a good idea regardless of the trading system.