Prudent Risk Management Is The Only True Edge In TRADING
- Thread starter Buy1Sell2
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FALSE
You do not understand the standard definition of "positive expectancy". The definition that is used by mathematicians, hedge funds, casinos , pro gamblers, etc
This term is independent of money management and refers to your advantage or disadvantage on your bets.
IE- if every dollar wagered is worth 1.20 ( in the long run ) that is positive expectancy. If every dollars is worth 95 cents in the long run that is negative expectancy.
Betting on a fair coin flip at even money would have neutral expectancy.
Betting heads on a coin rigged to flip heads 60 percent of the time gives you positive expectancy and gives your opponent negative expectancy.
Anothet example: the house edge on the standard double zero roulette game is 5.26%. So in the long run you are losing roughly 5 dollars and 26 cents for every 100 dollars you bet if you play this game.
There is no prudent money management scheme that will make you a winner in the above mentioned coin flipping game or in the roulette game.
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However, yes, without reasonable money management a trader will probably lose his account even if he has an advantage.
If his money management is horrendous, he will definitely lose his account if he keeps trading.
There is no money management scheme that beats a negative expectancy game like trading badly over and over, like if your entries were based on coin flips and held to the days end (slippage and commissions)
What is needed is both:
1. A worthwhile advantage on your trades
2. Reasonable money management
... this is how top traders, hedge funds, casinos, pro gamblers do it.
I agree with the spirit of your nod to the importance of good risk management.
However, in point of fact though, your post is not correct because "positive expectancy" has an exact and technical meaning.
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It is only false when you do not understand it.
Again, prudent risk management is a fundamental requirement for successful trading or investing (making money consistently), it is not an edge. No matter what you think or say will not change this fact. If you do not accept the fact, then I doubt your ability to trade or invest successfully.
You can of course prove me wrong at any stage if you like, for all you need do is back up your words with proof in relation to Prudent Risk Management Is The Only True Edge In TRADING
3 x 7 = 21
Only a person with no experience will trade or invest without stops. Stops are your way to prevent you losing too much of your capital on a small number of trades. Averaging down is not the way to make money trading or investing (it might work some times but will eventually catch you out, and it will be when you do not expect it, wiping out months of hard work in a few seconds, minutes, hours or days (depending on your style). Any person who supports averaging down is showing their ignorance, even though they might not be aware of it.
As you rightly say, in order to make money consistently (success) trading or investing, it is a requirement to use proper risk management and sound trading or investing techniques. The plethora of techniques that are easily offered to those who want to partake in the financial markets are not worth very much in relation to success. Understanding why is the first step to achieving any meaningful success, and like all successful businesses, success breeds success.
One does not have to be that smart to see what the biggest obstacle is, and the "smarter" you think you are the greater the time it will take to see any success worth talking about, if any at all.
Now, I am a big fan of Van Tharpe's teaching and PRM but any trading system still needs a positive expectancy to make money. I know this is a long post but please read in its entirety. Or if you think I am full of it just ignore me.
PRM actually is to eliminate or minimize chance of ruin and maximize gains while keeping downside to a minimum or acceptable level based on the trader's view of acceptable drawdown. It in and of itself does NOT make you a profitable trader.
Lets take a system that is 50% win and 50% losses. If this system only made on average $1 reward for every $1 risked average (a TRULY 50:50 Coin Flip system) you would STILL be a loser. Commissions would eat up your funds not to mention NO ONE trades exactly perfectly every trade. So your exactly perfectly average coin flip 50:50 system is not likely to be traded perfectly and result in more losses How are you going to apply PRM to that system and get a positive expectancy as you said "PRM GIVES you Positive Expectancy"? Dont say "I let the winners run" because then THAT SYSTEM is completely different and is now a positive expectancy system by making the $1 loss smaller than the $2 gain you made by letting the winner run. So this 50:50 coin flip system now with positive expectancy keeps losses small and winners larger so you are profitable. But if the system was truly even in terms of $$ ($1 Risk:$1 Reward) you would lose in the long run. You can NOT adjust your risk with PRM to minimize losses because you are also minimizing wins if every $1 risk makes $1 in 50:50 system. It does not matter if you lower your risk to say $.50 to keep the risk smaller because your winners are also $.50 in this perfect coin flip system. Letting "winners run" (making $2 for $1 risked) and "cutting losses short" by definition is a positive expectancy system. PRM did not give you that. Letting winners run gave you that positive expectancy.
PRM simply MINIMIZES DRAWDOWN. It does not give you the "edge". If you have a perfect coin flip in 10,000 flips of the coin you can have as many as 19 losers in a row. Any Monte Carlo analysis will show this. PRM minimizes your drawdown during these streaks so that you can survive long enough to make money when the table turns in your favor again with a winner. If you risk 2% per trade and have 19 losers in a row you now have lost 38% of your capital. If you risk 0.75% of your account per trade you have lost only 14.25% of your capital. On a $100k account you would have $62k and $85,750 left respectively. In the 1st case you need 61% return to get back to even and the other PRM scenario you need a 17% return to get back to even. PRM minimizes DRAWDOWN. Letting winners run gives positive expectancy to a system that has PRM to minimize drawdown.
Lets look at a 75%:25% win rate. In that case a $1 win for every $1 risked makes you profitable because you have on average 3x as many wins as losses. Now if you let that system run with "letting winners run" and make $2 on wins and lose $1 on losers then now you have a VERY NICE system that makes on average $6 for every $1 lost. In fact this 75:25 system could even have a $.50 win for every $1 risked because you would be up $1.50 on average (3 wins for every 1 loss). But again this is a positive expectancy system. PRM makes sure that you dont lose everything when you lose. If in the extreme you risked 50% capital per trade you would get wiped out after a couple losers. But this positive expectancy system lets you now risk more than 1% because you have a higher win rate (and fewer losers in a row) so your drawdown will be less than a 50:50 system. PRM here MAXIMIZES your profit by allowing you to adjust your % of capital at risk UP from the typical 1% rule yet still keeping your drawdown to a manageable level since you have more winners than loser.
Lets take one last extreme example. Lets say you have a LOTTERY system you have developed and you win 1:400 million trades but it takes 1 million trades a day. But when you win you win $50 BILLION for every $1 risked. This is a true lottery type of system that has a HUGE Positive Expectancy. PRM keeps you in the game when you have all those losers. If you have a $400 million hedge fund lets say and risk $1 per trade you should make $49.6 BILLION after 400 trading days on average, Right? Does risking the entire account to win the lottery sound prudent? NO of course not. Why? because you have a TON of losers before you win big and drawdown would be HUGE here and your clients would likely close out the fund withdrawing their money in droves. BUT,....PRM means you could risk ONLY $0.01 per trade. After 400 million trades you have lost $4 Million dollars (Max of only 1% DRAWDOWN ON AVERAGE but you could have millions of more losers in a row before you actually win the lottery because the win rate is so low). NOW that winner comes and you make $496 MILLION on your $0.01 trade. PRM made sure you were still alive to take that trade. PRM MINIMIZES DRAWDOWN. KNOWING how to apply PRM maximizes whatever edge you have.
I hope this helps someone out there.
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The Big, Fat Turd vs The Grey, Dull Rock
Let's say your trading system provides you a long-term expectancy equivalent to a big, fat turd.
Does it matter how many times you slice up that turd (minimizing losses)? As long as your rules yields poop, it won't really matter how you choose to slice it up, or however much more you produce (maximizing returns).
So to improve, one must recognize poop for poop, and start appreciating something else entirely, those grey, dull rocks for instance. Just because some particular poop always seems to shine apparently, one must strive to learn its true value. For, if it was truly valuable, someone else would've snatched it up already!
So it is with life. Over time, those grey, dull rocks accumulate, becoming an unstoppable force. Luckily, most people hate boredom and are drawn to big shiny.
Let's say your trading system provides you a long-term expectancy equivalent to a big, fat turd.
Does it matter how many times you slice up that turd (minimizing losses)? As long as your rules yields poop, it won't really matter how you choose to slice it up, or however much more you produce (maximizing returns).
So to improve, one must recognize poop for poop, and start appreciating something else entirely, those grey, dull rocks for instance. Just because some particular poop always seems to shine apparently, one must strive to learn its true value. For, if it was truly valuable, someone else would've snatched it up already!
So it is with life. Over time, those grey, dull rocks accumulate, becoming an unstoppable force. Luckily, most people hate boredom and are drawn to big shiny.
I didn't understand why did you exclude 'making winners run' from the concept of PRM when it's the foundation of PRM. Who said that applying PRM must have payout equal to risk? You aren't in a casino, you make your own odds by making sure you participate in bigger oscillations ie if envisaged move is 100 points you don't set your stop to be 100 points.
Why setting a stop at 10 points whilst keeping target at 100 points isn't part of PRM?
Because you can set your target at infinity if you want. You dont MAKE your own odds. IF i did o would make my odds 100% that I make $1000. It isnt an ATM that you just withdraw money out of the market. I frequently have trades that have a R:R of 1:6 when I initiate the trade. I don't know about you but I usually get stopped out with a trailing stop before I reach that target. Then there is a retracement and I reload and off we go again. As it gets closer to that target price the trade starts to have less reward. Some may say "see that was poor risk management because you should let the winner run". I would say that was PRM because I cut my losses short maximizing profit on the trade. So by cutting this loss short I allow for a retracement and I reload on the trade. This actually gives me an ability to Make MORE than the move on the trade. As a price retraces on you you are "RISKING" all your profits. As the old saying "No one ever went bankrupt taking a profit". What if you are wrong and the target price is never hit and a reversal happens and you suddenly lost all you profits. now you turned a winner into a loser. PRM is BOTH letting winners run and cutting losers short but this saying goes FOR THE DURATION of the trade, not just at trade entry. Throughout the trade you are RISKING profits every penny that goes against you after you have a paper profit. PRM helps you MINIMIZE LOSSES of PROFIT too.
Also you CAN set a stop 100 points below and have a 100 points target IF you WIN RATE is high enough. If you risk $100 every trade and make ON AVERAGE $100 per trade you can make money as long as you win more than you lose. If 70% win rate you have 7/10 winners. I just made $100 × 7 = $700 and lost $100 × 3 =$300....For NET PROFIT of $400...a POSITIVE EXPECTANCY.
It is that your own statistics of you trade record determines what your average win rate and what expectancy is per trade. Win Rate is how many win % you have. You can have a 20% win rate and still make money as long as you have Positive Expectancy (Your TOTAL WINNING PROFIT is GREATER than the TOTAL LOSING AMOUNT) over the course of your statistics.
There is no such thing as a negative Expectancy system that is still profitable
People are confusing what positive Expectancy is. Expectancy takes into account the win rate.
Expectancy = (Probability of WINNING × AVERAGE $WIN) - (Probability LOSING × AVERAGE $LOSS)
So if you average loss is $5000 but you only lose 1% of the time and your average win is $1 yet you win 99% of the time you STILL have a NEGATIVE EXPECTANCY....a LOSING SYSTEM. NO amount of management of risk will change that. Your own statistics determine that. That $5000 loss could have occured on bad news where a stock or trade GAPS lower suddenly. Maybe it blew through his tight stop loss. Changing target price and setting your initial stop loss tighter and tighter is not going to change that $5000 loss. Your own trade records determine these stats.
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