Risk per trade - Should I vary lot size with the size of the stop?

The simple answer: Yes, varying lot size is ideal, but there’s more to the calculation than just points to risk, and it’s fair to risk less when you find it difficult to calculate in the seconds until a bar close. However, you might see a very small signal bar with good context and believe it’s not a great time to use the same dollar risk and price action stop you would on a strong breakout. This intuition is correct—either the risk is higher than it appears, the reward is lower than it appears, or the probability is lower than it appears. Trade smaller, wider stop, or even no trade.

Longer answer: In theory, the optimal size to risk on a trade for maximum growth rate is a percentage of capital. That is, there is some fraction f* (which is a function of risk, reward, and probability) that will grow your account the fastest (or in academic terms: it will maximize the expected geometric mean of returns). Undershoot this and your equity curve will be less thagomizer-shaped—trading f* is an emotional roller coaster. Overshoot this and you will not grow your account any faster—in fact, crank it high enough and it can turn a winning Trader’s Equation into a trading plan that loses on its average trade! More on that later.

There’s a formula called the Kelly criterion that can tell you this percentage if you have constant odds (risk and reward) and probability as in a game of chance; but it has little relevance to trading in practice because these variables aren’t constant before or after you enter a trade, and can be very hard to estimate besides.

You may hear rules of thumb that come from practical experience to not have more than 1% or 2% of capital at risk on a trade, or at a time, or in a day, or between a portfolio of trades in markets with some correlation. This is probably more conservative than f* truly is for successful traders’ edges, but a loss of 1% is noticeable enough, and scaling into trades beyond 1% gets very bad if and when you have a loss or two.

Now, how can trading too big a percentage hurt a winning Trader’s Equation? Let’s contrive an unrealistically great scenario: 50% probability with 1.5 reward to 1 risk, no risk of ruin, no fees, high frequency. If you risk 1%, your capital is either at 99% or 101.5% of what it was, for an average of 0.242% return on a trade (square root of 0.99 times 1.015, subtract 1). If you risked the full Kelly fraction, one sixth, this changes to 83.33% and 125%, for an average of 2.062%—your stomach lining might not enjoy this, but in our thought experiment, that should go away after a few thousand of these. But if this trader crossed the line from trading into gambling and risked one half, this changes to 50% and 175%, “making” -6.459% on the average trade. Despite having an amazing performance on the trades, this gambler is losing money faster than the steel-willed rational actor can make it!

So, a trader in a drawdown must reduce size for this reason even if there are no problems for that trader to address. By risking consistent percentages (and small ones at that, and smaller still with less conviction), a trader’s concern is primarily with trading well, as it should be.

Great answer, thank you. What do you think about having a set daily target and then calling it a day (say 1-3 times your max risk on a trade), vs just taking good setups and not focusing on the actual money?

There are people who know they must stop themselves from getting greedy after a “hot hand”, and more power to them. I don’t believe in doing that; I believe in maintaining full discipline consistently throughout set hours. You should never feel pressure to make a target, and there is no rational basis for capping the upside, only the downside (whether one is making or losing money on the day, there’s probably a reason for it, and to succeed, discretionary traders must be good at evaluating conditional probability without necessarily knowing the reason or ripping through a book on Bayesian statistics).

For example, yesterday was a day where arguably the best trade happened to emerge on bar 72 or 73. In my view, I’m either waiting all day for that possibility, or I’ve clocked out well before that and shouldn’t worry about it (many European professional traders and American West Coast traders before going to a job are finished somewhere around bars 24 to 36). In actuality, I was trapped on the wrong side of it, which is how I found out it was so great!  😀

I recall a London prop firm on YouTube that showed a chart where between the four combinations of having or not having a daily stop or a daily target, their group’s best results came from having a daily stop but no daily target. It stands to reason: a risk manager at an institution (or a supervisor of algorithms, as is often the case now) is, on a basic level, trading the performance of the traders. If you knew there was a trend, would you rather trade with a target and no stop, or a stop and no target? It might be more important in principle than said risk manager knowing institutional-grade risk management ideas like VaR and MPT.

I agree that long term having a set daily target may not be the best idea, and definitely can see having a set daily stop is a good idea.

However, I have been having a lot of trouble gaining consistency, it seems like 80% of the time the market reaches my swing targets but I have been making too many mistakes, and getting out of winners too early (or having my sights set too high without taking into account the ebbs and flows even in a trend), and sticking with losses too long.

I think I will try the daily target for a couple of weeks and see how I go - it might help me gain some consistency and confidence/belief, because I know I can do this, I just need some hard evidence. And I have shown that I often have a reluctance to take profits, so it should help with that. It might switch my mentality a bit from looking for a lottery ticket win, to the market is my ATM.

I tried it today and walked away from the screen with 3x my trade risk. It was literally the best feeling at the end of a trading day that I have had in a long time. It's funny that all the advice is to stop looking at the money, but today it helped me get out of trades and lock in decent profits when they became available. 

Market proceeds to drop another 60 points after I exit my shorts.... 🤪