This is the first version of my risk management guide which will be updated and finished in the next few weeks. There is so much I wish to cover but at the same time I want this piece to reach you as soon as possible so you can start implementing the concepts presented in this version. As you might have noticed, there is a Greek mythology character called Caerus on the front page of this PDF. He represents opportunity, luck and favorable moments and this is something we will go through in this book. Trading is not just a random game of pressing buy and sell buttons, at least not in the long run. No matter how good your trading strategy is, your win rate will never be 100%. Losses are a part of the game and your job is to expect them and control them. What you really need is an edge that plays out profitably not over a few trades but over the course of a series of them. The outcome of any trade should either be a big win, small win or a small loss, never a big loss. This is where risk management comes in. You have to study it carefully and apply it to your trading system if you want consistent results and actually become a successful trader in the long run. Trading is a game of probabilities and you have to treat it as such. It is about setting up your game plan and finding ways to gain an edge to put the odds in your favor. Hopefully this article is a good start and it will help you on your journey.
If you want to be a trader (and not a gambler), your number one priority becomes protecting your capital. This is why you have to consider the risk you’re taking when trading. Risk or risk per trade is how much of your capital you’re willing (risking) to lose on a single trade if it goes wrong. Every trader has a different risk appetite so there are different opinions on what is the right amount of risk. Some say below 1%, others say somewhere between 1% and 5%. Let’s say you decide to have a fixed risk of 1% of your account balance on a single trade. This means that if you lose 20 trades in a row, you still have roughly 80% of your capital. Having a fixed risk % also benefits you because of the power of compounding and reverse compounding - on a losing streak, your losses (in $) get smaller and smaller and on a winning streak, your risk and therefore also reward (in dollar value) will get bigger and bigger. Some traders also practice “adjustable risk per trade” which means lowering your risk per trade after each consecutive loss on a losing streak. It is important to understand that risking eg. 1% on a single trade does not mean that your position size is only 1% of your capital. It just means that you will only lose 1% of your account balance in case your stop loss is hit.
<aside> 📌 Risk amount: CAPITAL SIZE ($) x RISK PER TRADE (%)
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Example: Your capital size is $10,000 and you decide that your risk per trade will be 1%. 1% of $10,000 is $100 ( $10,000 x 0.01). This means that you will only risk $100 per trade.
The R:R ratio is used to evaluate trading decisions based on risk and reward. It represents the ratio between the risk you are taking and the expected return. Or in other words, it compares the potential profit of a specific trade to its potential loss.
RR can be calculated using the “Long position” or “Short position” option in Tradingview or manually with the following formulas:
<aside> 📌 Risk:reward ratio: *(ENTRY PRICE - STOP LOSS PRICE) / (TARGET PRICE - ENTRY PRICE) for longs (STOP LOSS PRICE - ENTRY PRICE) / (ENTRY PRICE - TARGET PRICE) for shorts
<u>or simply
PRICE DISTANCE TO STOP LOSS / PRICE DISTANCE TO TARGET</u>*
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To put it simply, if you have a R:R ratio of 1:2 (also called 2R), it means you’re risking 1 unit to potentially make 2 units. If you have a R:R of 1:4 (also called 4R), it means you’re risking 1 unit to potentially make 4 units. I’m sure you have seen traders talking about their trades in terms of R, for example a +2R win or -1R loss. It is a fairly simple concept used to look at the trades and their results in terms of R-values and R-multiples. The key idea here is that all of your profits and losses should be related to your initial risk. For example, a +XR multiple is a profit that is X times greater than the initial risk and a -XR multiple is a loss that is X times higher than the initial risk. R-value - The initial risk taken in a given position (defined by the initial stop loss) R-multiple - Profit or loss expressed as a multiple of the initial risk
Example. $ETH is trading at $1700 and you want to enter a trade with a target at $1,730 and stop loss at $1,690. The R:R ratio here is 1:3 ($10 / $30). You’re risking $10 (distance to stop loss) to make $30 (distance to target), which means your R-value (initial risk) is $10. Let’s say the trade is successful and you exit at $1,730. Your profit can be expressed as an R-multiple: +3R (3 times the initial risk). Second scenario happens and your stop loss is hit. Your loss can be expresses as an R-multiple: -1R (1 time the initial risk). Now let’s say the price goes down to $1670 and your stop loss isn’t triggered. Your loss as an R-multiple would then be -3R (3 times the initial risk).
In general, you should be looking for trades where the reward is higher than the risk. If the R:R ratio is worse than 1:1 (eg. 1:0.7), that means that the potential risk is greater than the potential reward. If the R:R ratio is better than 1:1 (eg. 1:2), the potential reward is greater than the potential risk. You want your losses to be -1R or less and your wins to be greater than +1R. Traders usually have a system that often produces similar trade opportunities in terms of R:R which helps them build a consistently profitable system in combination with their win rate.
Win rate represents the ratio between your winning and losing trades. Or in other words, it shows how many trades you win out of all your trades. It can be calculated as:
<aside> 📌 Win rate: NUMBER OF WINNING TRADES / TOTAL NUMBER OF TRADES
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Example: You take 25 trades with 14 of them being winners and 11 of them being losers. Your win rate is 14 / 25 = 0.56 = 56%. It is important to understand that win rate by itself doesn’t mean much. You might have a high WR but if your losses are larger in value than your wins, you are still not profitable. This is why you need to consider both WR and RR. A higher win rate means that your RR can be lower and a lower win rate requires your RR to be higher. Many professional traders have a system with a win rate of 40% which only requires a R:R ratio greater than 1:1.6 to be profitable. The following calculation will tell you what is the required R:R to break even based on your win rate which means you have to get a slightly better RR than the result in order to be profitable.
<aside> 📌 Minimum R:R to break even: (1-WIN RATE) / WIN RATE
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Example: Your win rate is 60% (0.6). Here is how to calculate your required R:R = (1-0.6) / 0.6 = 0.4 / 0.6 = 0.66667. Your R:R to break even should be around 1:0.66 or better if you want to be profitable.
This next calculation will tell you about the minimum required win rate to break even, based on your R:R ratio which means you have to get a slightly better win rate than the result to be profitable.