The Trading Guide Part 4- Setting Win/Loss Guardrails
If you are new to trading there are a few simple rules you can follow that will greatly increase the likelihood of surviving and succeeding.
Our first rule was that your daily account limit should be set at 5% . Our second rule was that you should stop trading for the day after losing 3 times in a row. Our third rule was that you should have a maximum of 3 open trades.
Our fourth rule is about setting win and loss guardrails.
The psychological effects of winning and losing are vastly different. We subconsciously (our system 1) react a lot stronger to losses. Read more about loss aversion here
For losing trades:
It’s important to minimise your losses, and the way to do this is by capping the loss on each trade before you place it. Then, you don’t have the chance to react irrational after losing, whether that be by staying in the losing trade for too long, or putting on emotional trades that contribute to a losing streak. By capping your losses on each trade, you protect your capital.
For winning trades:
It’s tactical to target winners to offset losses, and these targets should be refined based on how often you win. To do this, you need to know how many trades are winners, and how these winners compare to our losers.
How often you win is measured as your win rate. It is the number of winners relative to the total number of trades.
If you make 10 trades with 6 of them winners then your win rate is 60%.
How much you win is measured as the risk to reward ratio. It is calculated as the average size of the winners divided by the average size of the losers.
Let’s look at 2 examples of break-even situations to explain the concepts.
Break-even is when your P&L is zero, you are neither winning nor losing.
Firstly: You trade 4 times resulting in 2 winners and 2 losers. Each winner is $100 and each loser is $100.
After 4 trades your P&L is break even at $0.
In this example your Win Rate is 2/4 or 50%.
Your Risk Reward Ratio is 1 ($100/$100) as we are considering the average of your trades.
Here is a second example: You trade 3 times with 2 winners and 1 loser. The winners are $50 and the loser is $100.
After 3 trades your P&L is break even at $0. Your Win Rate is 67%. Your Risk Reward Ratio is 0.5. ($50/$100).
It’s not necessary to have a high risk reward and a high win rate. In fact typically, a high risk:reward ratio will have a low win rate and vice versa.
Unless you have a very specialised strategy, a good risk:reward is to aim for winners to be slightly larger than losers.
So how do you get a good risk: reward rate? Setting up trade guardrails allows you to set your personal goals for your risk:reward ratio.
We suggest targeting your winnings slightly larger than losers by setting 1% of Account Balance to be the maximum loss, and 1.2% of account should be the target profit.
By doing this, you will have a winning strategy once you win rate is close to 50%.
Protect your capital by controlling losses on every trade.
Target winners to be slightly larger than losers.
Attempt to win 50% of the time.