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I believe we should base our Trader's Equation calculations based on initial risk and not actual risk. The reason is that we don't tighten our stops if the market goes sideways right after entering. The premise could still be valid until the stop is hit, and hence there is no real clue to tighten the stop and reduce the actual risk on the trade. So, on losing trades we're using actual risk, and on winning trades, we're fooling ourselves by thinking that we've made many multiples of actual risk, whereas, in reality, the profits are 1-2x the initial risk.
Can someone clarify if this is right?
I don't know about the math which way is correct but from experience of trade management, I'd say we don't let our full stop get hit (initial risk) right? Maybe the only exception is a swing setup where the stop is small and it goes against our entry immediately after triggering. But again, also most swing setups, result in either big win, small loss or more or less break even, so the average loss is < than initial risk.
Good example is AI or break out trading, where the stop is big (initial risk), if the follow through is really bad and disappointing I think most will be able to exit around half loss (-0.5R). Only 10-20% of the time your full initial risk stop gets hit. Again, from experience, in this style most of my winners are 0.6R and losses around 0.4 to 0.5R, with probability around 65% it is a profitable strategy.
TLDR: actual risk makes sense in active trade management context
So, on losing trades we're using actual risk, and on winning trades, we're fooling ourselves by thinking that we've made many multiples of actual risk, whereas, in reality, the profits are 1-2x the initial risk.
Just a correction, I meant to say, we're using initial risk on losing trades and actual risk on winning trades.
@yuri Yes, it makes sense if we adjust stops on both winning and losing trades. As a beginner, I'd like to leave the stops and profit targets alone and let the trades work. This is primarily because I want to make fewer decisions starting out and start adjusting stops only after I feel comfortable due to experience in the markets.
Regardless, I think the strategies are profitable even if we use initial risk on both winning and losing trades.
Al mentions that it is a good trader's equation to take profits on 1x or 2x actual risk however I'm confused since position size can only be calculated off of initial risk (actual risk is hindsight). So if I exit on actual risk being 2x my actual profit may only end up being something like 0.5x depending on how wide my stops are. If I'm exiting early at 2x actual risk and avg only around 0.5x but losing 1x when my stops are hit, how is this a profitable exit strategy?
I'm probably missing something here but actual risk just seems like hindsight trading to me
As a quick follow up, I know Al says that it is reasonable but often not the most ideal exit but still my hang up is on the reasonable portion of the claim. Seems like you take small winners often and full losers in this scenario
I have been always confused by this as well, so I usually do everything in initial risk and don't worry about actual risk. If I am not moving my stop, till my profit target is hit anyways, I don't have to worry about actual risk.
I do believe taking profits on a multiple of actual risk makes good math because doing so increases probability.
The 3 variables when structuring a mathematically rational trade are Risk, Reward, and Probability.
The smaller the distance your profit taking limit order is to your entry compared to your stop loss order, the higher the probability of your trade.
When combining the correct stop with taking profits using actual risk; and assessing probability by reading the price action, you are taking higher probability trades and so to have a positive trader's equation you need to win 75% or more of the time for it to make sense
One can further increase their traders equation through active management in multiple ways.
FINAL POINT:
SP, Al says the 3 things a trader needs to be good at to be a consistently profitable trader are: 1. Read price action 2. Structure Mathematically Rational Trades. 3. Management of those trades.
By choosing to set the trades and walk away with each one you are not working on trade management.
walk away with each one you are not working on trade management.
But he also talks about the Walmart trade 🙂 - take a reasonable swing entry, set your profit and stop loss and walk away.
I think it depends on what personality you have, where you are in your trading journey.
The trader equation is based primarily on the actual risk which is the minimum, of course you can structure your trade based on the initial risk, but the decision of which to use depends on the context and momentum.
The market is forming a trading range at the opening whose size is less than 25% of the average daily range? so probably when the market is always in mode you will get 2 or more times the initial risk.
The market started a trend from the open, but you entered a little late and had to set the stop far away? then it is probably better to try to look for 1x-2x times the actual risk because 50% the strong moves on the open fails. Or you can scalp out part for two times actual risk and swing the balance until a midday reversal or until the close.
You entered in breakout phase, market is clear always in, big bars, no shadows or overlap, you going use a wide stop right? you can look for 1x time initial risk because is a high probability trade. Think about it, after this breakout the price pullbacks 50%, so two times your actual risk (50%) is equal your initial risk.
You can only know the actual risk in hindsight, after the price goes against your stop.
You can use actual risk in your trading if you wish, but it is not the trader's equation. Al says you can take profits at 2x actual risk and have a profitable trader's equation, but this does not mean that the actual risk is what is used in the actual equation.
The trader's equation is ---- (Prob. of win * Avg Win) - (Prob. of loss * Avg Loss). There is nowhere in that equation to plug in actual risk, because that isn't how much you lost on your actual losing trades... that is just the minimum distance for a stop loss to not get hit on that particular trade.
If you make all trades the same risk, then instead of thinking of avg win/loss in terms of points or dollars, you can convert it to R ("risk"). Thus your initial risk is always 1R (or result of -1R), and your average win is a multiple of that. If you do no trade management, then your losses will always be -1R in this case. Note that if you do decide to take an early exit, this actual loss amount would not be your "actual risk" either. The actual risk might be 5 pts or 0.8R, yet you exited at 2 pts or -0.2R.
Side note -- "trader's equation" (TE) is just a term Al decided to use for something already existing in math for similar win/loss scenarios involving probability (such as poker), that we call Expected Value (EV). When you calculate the TE (aka EV), you are calculating the average amount you expect to win or lose on any given trade. So if you get a result of 0.2 (profitable!), then after 10 trades, you would expect to on avg win 2.
Hi S,
- Initial Risk refers to the predetermined amount of risk a trader is willing to take on a trade before entering it. Initial risk is crucial for position sizing and for evaluating the potential risk/reward ratio of a trade. Traders use initial risk to ensure that the trade aligns with their overall risk management strategy and to prevent any single trade from significantly impacting their trading capital.
- Actual Risk represents the amount of risk that materializes during the course of a trade. It can differ from the initial risk due to factors such as slippage, gap moves against the position, or if a trader decides to move the stop-loss level during the trade. Actual risk reflects the real-world outcome of a trade, which may not always align perfectly with the planned initial risk.
When to Use Which:
- Use Initial Risk when planning a trade, determining position size, and assessing whether a trade fits within your risk management parameters. It helps in making systematic, disciplined trading decisions before market forces come into play.
- Actual Risk comes into consideration after a trade is entered. It's useful for evaluating trade management decisions and post-trade analysis. Understanding actual risk helps traders refine their strategies by incorporating lessons learned from the discrepancies between expected and realized risk.
In essence, initial risk is about planning and preparation, while actual risk is about adaptation and learning. Both are integral to successful trading, allowing traders to maintain discipline before entering a trade and to adapt and learn from the trade's outcome.
Here's a hypothetical trade example:
### Trade Setup: Buying a Pullback in a Bull Trend
- Initial Setup: You identify a strong bull trend on a 5-minute chart and decide to buy on a pullback to the moving average, expecting the trend to resume. The current price is $100, the moving average (your entry point) is at $99.50, and you place a stop-loss at $98.50, setting your initial risk at $1 per share.
### Expected Scenario (Based on Initial Risk)
- Entry Price: $99.50
- Stop-Loss: $98.50
- Initial Risk: $1.00 per share
- Target Price: $102.00 (assuming a 2:1 risk/reward ratio, targeting a $2.50 profit per share)
### Actual Market Movement and Managing Actual Risk
- After entering the trade at $99.50, the price drops to $98.75 but doesn't hit your stop-loss and then quickly reverses upward, indicating strong buying pressure and a potential failed breakout to the downside.
- Observing this, you adjust your stop-loss to $98.75, reducing your actual risk to $0.75 per share instead of the initially planned $1.00.
- The market resumes its upward trend, reaching your target of $102.00.
### Final Outcome with Actual Risk Management
- Revised Stop-Loss: $98.75
- Actual Risk: $0.75 per share (reduced from the initial $1.00)
- Actual Reward: $2.50 per share
- Improved Risk/Reward Ratio: Instead of the initial 2.5:1 (based on a $2.50 reward and a $1.00 risk), the final ratio becomes approximately 3.33:1, significantly improving the efficiency of the trade.
### Key Takeaway
By actively managing the actual risk and adapting to the unfolding price action, you were able to improve the risk/reward ratio of the trade. This scenario highlights the importance of being flexible and responsive to market behavior. Adjusting stop-loss levels in response to signs of strength (in this case, the price rebounding off a level closer than the original stop-loss) can reduce actual risk and enhance the potential outcome of a trade.
Hope this helps,
CH
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