Part I. Risk Management Framework

Pipruit: I see. Sounds logical, but sir, I’ve heard that there are brokers that allow you to choose any lot size. So, if I choose 0.001 lot, probably I can trade with just 25 bucks.

Pipruit: Hardly sir, but I suppose that they will spread somehow among profitable trades…​

Pipruit: Sir, some idea has come to me, I’m just wondering – since our assets becomes lower with each losing trade – should we apply the 2% rule for initial assets value or to current assets value? In other words, should we reduce trading lot size if we assume that stop-loss distance will remain constant?
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Pipruit: But sir, in this case it will be much harder to return all loses back, since with smaller positions we will have to earn more pips to return previous losses.​

Commander in Pips: Absolutely. That’s why it is so important not just earn pips, but to save them. This is even more important, I suppose. To illustrate it, let’s take a look at following table:

Trade #	Assets Value	Supposed 2% Loss	Loss, %	Distance to Breakeven,% Compared to the Rest of Assets
0	10,000	200	0%	0%
1	9,800	196	2%	2%
2	9,604	192	4%	4%
3	9,412	188	6%	6%
4	9,224	184	8%	8%
5	9,039	181	10%	11%
6	8,858	177	11%	13%
7	8,681	174	13%	15%
8	8,508	170	15%	18%
9	8,337	167	17%	20%
10	8,171	163	18%	22%
11	8,007	160	20%	25%
12	7,847	157	22%	27%
13	7,690	154	23%	30%
14	7,536	151	25%	33%
15	7,386	148	26%	35%
16	7,238	145	28%	38%
17	7,093	142	29%	41%
18	6,951	139	30%	44%
19	6,812	136	32%	47%
20	6,676	134	33%	50%

So, from table you can see, that even if you will adjust loss value proportionally to the rest of your assets, you will have to earn more of a percent to get back to breakeven than your drawdown is. For example, after 20 loss trades your drawdown will be 33% from initial assets value. But since now you have just $6,676, you have to earn almost 50% to return back to 10,000$. Ultimately if your drawdown will be 90% and you will rest with just $1000, then how much you will have to earn in percents to return back to $10,000?


Commander in Pips: Yes, this is a tough task to do – make a 9x times of your account. So, let’s take a look at this process visually with the following chart:


Commander in Pips: Absolutely. That’s why when you’ve got a solid drawdown it will be harder and harder to return all loss back to breakeven, i.e. initial assets value.

Couple of words about Reward/Risk ratio

Commander in Pips: Here is another issue that lets you understand why a trading journal and statistical numbers are important. In fact, Reward/Risk ratio is a relationship between your potential loss and potential profit in each trade. For example, if you’ve placed stop loss to 50 pips, while your profit has placed at 100 pips, then your Reward/Risk ratio is 2:1 or simply 2. Now, let’s understand why statistics are so important here - mostly because there is a balance between your system's effective strength and your reward/risk ratio. For example, if your trading system shows 50% of profitable trades, that your reward/risk ratio should be greater than 1. Otherwise you will stand at or below breakeven and will not earn anything. On following table we will show edge reward/risk ratios depending on your system % Win trades ratio:

% Won Trades	Minimum Reward/Risk Ratio for Every Trade
10	must be greater than 9:1
20	must be greater than 4:1
30	must be greater than 2.3:1
40	must be greater than 1.5:1
50	must be greater than 1:1
60	must be greater than 0.67:1
70	must be greater than 0.43:1
80	must be greater than 0.25:1
90	must be greater than 0.11:1

This is very simple to understand. For instance, if you win just in a single trade from ten possible, you have to earn so, that compensate all loss in other 9 trades and get some profit. So you have to earn, say, at least 100 pips in 1 trade and lose no more than 90 pips in the 9 rest.

Actually, although we’ve pointed out that if you have super efficient system with 90 % winning trades you can let yourself to use just 0.1 reward/risk ratio – this is not wise. Statistically yes, you will earn profit, but logically there is no sense to take Reward/risk ratio less than 1 in any trade. A ratio of less than 1 skewed chances of success against you with many repetitions of such trades. A trader’s major task is to increase probability of success in any trade. That’s why he/she should not apply Reward/risk ratio less than 1 in any trade. Usually it is recommended to apply a 2:1 or even 3:1 ratio, but we have to point out that this is not a hard-rock ratio that could not be changed. If you will base your trades on a constant ratio this will lead to some problems – your targets could be too far, relative to what analysis tells you, you will trade too big of lots, or place too tight of stop-loss orders. Reward/risk ratio is a consequence but not the reason.

We recommend dealing with it as follows. Make your analysis of the market and estimate crucial levels for your scenario. Let’s suppose you intend to enter Long on EUR/USD from 1.3520 level on hourly chart and you have estimated that if market will break down 1.3470 area – this will significantly increase the probability of downward acceleration and your bullish scenario will have vanished. So, your crucial level is 1.3470 + some room. Hence, you will place stop somewhere around 1.3450 probably. Your risk is 80 pips.

Now estimate your target. Let’s suppose that nearest 0.618 target of some AB-CD extension stands at 1.3590 and initially you intend to take it. Here is your reward risk ratio is 7:8<1, and probably you have to reject this trade as ineffective.

If market will show some deeper retracement and your context for a long trade will still hold, say to 1.3490, then you can try it, because now you will have 100:40=2.5>1 reward/risk ratio.

The major mistake that many traders do with reward/risk calculation is force it to context, or force orders’ placement to reach a ratio greater than 1. This is quite unwise. Reward/risk ratio is a statistical measure but not a tool that brings you money. You may reach a ratio>1 by artificially placing orders, take bad trades and lose money – will it be nice, will you be happy that you at least had ratio>1? I don’t think so. This ratio is a tool, but not a goal to achieve. It lets you escape unwelcome trades. So use it accordingly. Besides, acting like this you break your trading system and do not follow the trading plan – one mistake triggers others.