Recommended by Daniel Dubrovsky
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In 2022, I conducted a study on risk management to see just how important it is to be consistent with your trading strategy. Even when you choose the correct direction, timing a trade is notoriously difficult and there is often an element of luck involved. As it turns out, there is a way in which you can compensate for this factor, and that is with the strategic use of risk-reward ratios.
This was done using a random walk experiment, in which code is used to simulate someone trading 100 times in a row. Whether or not a trade is profitable or not is determined by a fixed win/loss ratio. In other words, if we assume someone is lucky 50% of the time, then each trade has a 50-50 chance of being profitable. I was able to outline different levels of risk-reward ratios based on a trader’s luck.
This study is not perfect and has limitations. For one thing, we are only using the following factors: account size, positioning size, risk/reward ratio and luck. The cost of trading is not factored in. The code also assumes slippage is not an issue, meaning you can exit a trade at your designated stops/limits perfectly. Furthermore, the simulation assumes you trade exactly 100 times and that’s it.
The amount of risk you use will vary depending on your own personal level of activity. Generally speaking. the most active you are as a trader, the least risk you should take. There is also no human emotion factored into this study, meaning we assume the individual maintains their trading strategy perfectly for the 100-trade duration.
What the study finds is that offsetting increasingly lower levels of win/loss rates requires increasingly higher risk/reward ratios. In other words, if your win/loss ratio is about 50%, an ideal risk/reward ratio seems to be 1.6. If luck drops to 25%, then a 5.3 risk/reward ratio should be applied. Maintaining a well-balanced trading strategy is difficult, but overcoming this challenge helps make you a better trader.