Risk management demystified, examples and facts proven.
Updated
Greetings, I've spent a considerable amount of time trying to find the magic formula to stay profitable, I've read books, I've heard speeches, I've talked to pros, and I've stayed profitable, BUT... I've also lost quite a bit, I tried coding my strategy to see how it would really perform without sentiments, as executed by a machine and I was really suprised, no strategy surpassed the 40% profitability mark, so I decided to write down the axioms of my trading strategy and code them the best I could, these 5 axioms are:
For point 1 there are a lot of AWESOME indicators out there:
RSI, MACD, Stochastics, EMA, ALMA, BB, ichiomoku, renko, heikin ashi, and many many others, including my own SCSM indicator.
Point 2 isn't as important as many may think, and I will prove it later, however in order to avoid unnecessary risk I would say to avoid opening positions near major news releases.
Point 3 is the core of this idea and I will explain it in detail later.
Point 4 is important too, but not crucial for longer term trading, the really important thing about news announcements are the price spikes and the SL hunts, meaning you need to either widen your SL or close and reopen or tighten your SL considerably.
Point 5 is one of the most important points, there are many symbols to trade, and while I don't encourage trading everything at the same time, diversification helps reduce risk and why trade two weak currencies when you can trade a strong against a weak?
Now, to point 3, take a look at the chart of the idea, a profitable GBPUSD strategy on the daily candle over 10 years, blue arrows mean buy at the open, purple arrows mean either SL or trailing stop loss close or condition close (such as too tight BB for example), red arrows mean sell at the open.
Now, take a look at this chart:
https://imgur.com/v3IBKZO
I need to use external sources since TV doesn't show the strategy results in the snapshots, sorry for that.
Anyways, the strategy IS profitable even taking the opposite signals, HOW!?!?!?!, that makes no sense, or does it?
The trick is simple, though the number vary on each symbol, for this particular case (GBPUSD) the strategy opens a trade and places a SL 2400 ticks away from the price. Now, if price reaches 750 ticks in profit it activates a trailing stop loss of 750 ticks, meaning it will breakeven or earn cash no matter what. This may sound a little weird at first, since the risk is higher than the reward in theory, but remember that markets are VERY volatile, it's very possible for a trade to hit those 750 ticks in profit in one or two days if we're in a range, not to mention if we are in a trend. Let's tweak those numbers and set the signals normally but with a 200 ticks SL and see what happens...
For starters, THIS happens: https://i.imgur.com/cxccc8z.png
Meaning we get stopped too often, causing serious psychological damage, so I'm going to reduce the test to only 3 years and look the results...
https://imgur.com/8aI9xYo
Wow... just wow, too tight SL is a sure formula to losing, but what about tight TP?, let's do the math again, increasing the SL and using a small TP, for 200 ticks TP and 1000 ticks SL this is the result:
https://imgur.com/BItgQbL
I've reached the limit of characters for this idea, but I'm not done.
- 1- Direction of the entry, two ways to do it, follow the trend or pick a reversal point.
2- Entry point, if following the trend use momentum indicators, if reversing, candlestick patterns, S&R or trailing stop buy/sell orders are good.
3- Risk management, specially trailing stop loss.
4- News handling (this might be included in point 3, since it's mostly updating your stop loss before big news.
5- Favor the most likely trades out of the 29 pairs. (this one can't be done on trading view obviously)
For point 1 there are a lot of AWESOME indicators out there:
RSI, MACD, Stochastics, EMA, ALMA, BB, ichiomoku, renko, heikin ashi, and many many others, including my own SCSM indicator.
Point 2 isn't as important as many may think, and I will prove it later, however in order to avoid unnecessary risk I would say to avoid opening positions near major news releases.
Point 3 is the core of this idea and I will explain it in detail later.
Point 4 is important too, but not crucial for longer term trading, the really important thing about news announcements are the price spikes and the SL hunts, meaning you need to either widen your SL or close and reopen or tighten your SL considerably.
Point 5 is one of the most important points, there are many symbols to trade, and while I don't encourage trading everything at the same time, diversification helps reduce risk and why trade two weak currencies when you can trade a strong against a weak?
Now, to point 3, take a look at the chart of the idea, a profitable GBPUSD strategy on the daily candle over 10 years, blue arrows mean buy at the open, purple arrows mean either SL or trailing stop loss close or condition close (such as too tight BB for example), red arrows mean sell at the open.
Now, take a look at this chart:
https://imgur.com/v3IBKZO
I need to use external sources since TV doesn't show the strategy results in the snapshots, sorry for that.
Anyways, the strategy IS profitable even taking the opposite signals, HOW!?!?!?!, that makes no sense, or does it?
The trick is simple, though the number vary on each symbol, for this particular case (GBPUSD) the strategy opens a trade and places a SL 2400 ticks away from the price. Now, if price reaches 750 ticks in profit it activates a trailing stop loss of 750 ticks, meaning it will breakeven or earn cash no matter what. This may sound a little weird at first, since the risk is higher than the reward in theory, but remember that markets are VERY volatile, it's very possible for a trade to hit those 750 ticks in profit in one or two days if we're in a range, not to mention if we are in a trend. Let's tweak those numbers and set the signals normally but with a 200 ticks SL and see what happens...
For starters, THIS happens: https://i.imgur.com/cxccc8z.png
Meaning we get stopped too often, causing serious psychological damage, so I'm going to reduce the test to only 3 years and look the results...
https://imgur.com/8aI9xYo
Wow... just wow, too tight SL is a sure formula to losing, but what about tight TP?, let's do the math again, increasing the SL and using a small TP, for 200 ticks TP and 1000 ticks SL this is the result:
https://imgur.com/BItgQbL
I've reached the limit of characters for this idea, but I'm not done.
Note
We are still somewhat profitable, but what if I reverse the signals now?imgur.com/7tTevXZ
Still profitable, amazing isn't it?, too tight SL can destroy any strategy, but too tight TP can cut on your earnings as well, however if we need to choose it's better to have tight TP and wide SL than the opposite...
Now let's make a final interesting setup... if we get stopped or if we take profit, we open the trade again with the same parameters, the results?, see for yourself:
imgur.com/FUQ1pbt
Okay, so NO OVERTRADING, I repeat, NO OVERTRADING, that wasn't even the losses of 3 years, that was only 1 year, 50% of loss in only 1 year.
We've seen so far good workings of the SL, TP, Trailing Stops, overtrading, reversing signals and staying profitable... so what about leverage?, let's see what happens if we take this algo and increase leverage to let's say 1:10...
imgur.com/roEWaq0
Wow, crazy returns huh?, however note that the algo is a lot more sharper now, and more risky, what if we used 1:50?
imgur.com/O7U6FNO
The algo lasted 2 years before going boom... so you know, don't use too much leverage, trade with care.
This concludes the idea about risk management, stay tuned for the next two ideas about the different types of forex pairs and how different TFs are better traded in different ways.
Note
Please remember, if you enjoyed this explanation and found it useful, like it and share it with your friends, they will appreciate it as well.
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.