“Good decisions come from experience, and experience comes from bad decisions.”

It’s well-known that experience is the key difference between long-term success and failure in trading. To ensure our traders stay in the market as long as possible, we believe in gaining experience as cost-effectively as possible. This is why we consider a robust risk framework to be more important than a trade identification strategy.

Many short-term strategies are ultimately ruined by poor risk management. A prime example is Long-Term Capital Management, which is worth researching for its valuable lessons.

What Is Good Risk Management?

Good risk management involves a process that protects capital and operates independently of trading strategies.

Implementing Risk Management

There are various approaches to risk management, both numerical and heuristic. We believe these approaches should work together.

A solid risk strategy is built in layers, starting from a per-trade basis and expanding to daily, weekly, and monthly levels. For each trade, consider how long the position will be held and at what price you know you are wrong.

Hitting a stop loss on a single trade isn’t a huge issue, but if it happens repeatedly, it becomes a significant loss. This is where daily stops come in—if enough trades are losers, trading stops for the day. Consecutive losing days trigger weekly stops, halting trading for the week. The same principle applies monthly.

While this method might cause missed opportunities, it ensures long-term market participation, which is more important.

Risk management must be independent of trading strategies. When a strategy fails, the capital remains protected. Strategies will sometimes underperform due to market conditions—this is part of trading and can’t be avoided.

A trader with good risk management and a reasonable strategy will be more profitable than one with an excellent strategy but poor risk management. This distinction separates amateur traders from professionals, with professionals surviving periods of underperformance that might wipe out amateurs.

How to Work Out if a Trade Is Profitable?

Profitable strategies have a positive expected return 𝐸(𝑅) also known as the “mean return,” calculated as:

R=P(W) x W−P(L) x L

Where:

• R = mean return
• P(W) = probability of a winning trade
• W = return from a winning trade
• P(L) = probability of a losing trade (or
• 1−𝑃(𝑊)
• 1−P(W))
• L = loss from a losing trade

This formula helps compare high-value, low-probability trades with high-probability, low-return trades by providing a normalized value for R.

For more discretionary trades, P(W) can be set to 0.5, assuming market movements are equally likely to go either way. With access to backtested strategy data or trade logs, P(W) becomes computable.

Example Calculation of Mean Return – R

Assume the following parameters for our trading strategy:

• Probability of a winning trade 𝑃(𝑊): 0.6 (60%)
• Return from a winning trade W: £200
• Probability of a losing trade P(L): 0.4 (40%)
• Loss from a losing trade L: £100

Using the formula:

𝑅=𝑃(𝑊) x 𝑊−𝑃(𝐿) x 𝐿

𝑅=0.6 x 200−0.4 x 100

𝑅=120−40

𝑅=80

The mean return R is £80 per trade, meaning you can expect to make £80 per trade on average after accounting for both winning and losing trades.

Including Transaction Costs

Assume the total transaction cost per trade is £20. To be profitable, the mean return R should be greater than twice the transaction cost:

𝑅>2⋅Transaction Cost

𝑅>2 x 20

R>40

Since our calculated mean return R is £80, which is greater than £40, this strategy is profitable after accounting for transaction costs.

Risk Strategy Example

• Trading Capital: £100,000
• Daily Stop: 1% (£1,000), per trade is 0.25%, so it takes 4 losing trades to stop for the day.
• Weekly Stop: 3%
• Monthly Stop: 5%

Using a percentage basis for stops means that during drawdowns, risk decreases proportionally to trading capital. Conversely, as the account grows, risk increases, which makes sense intuitively. These hard stops protect capital when the trader or strategy underperforms.

Stops can be frustrating but allow for reflection. Taking a few days off after a string of losses helps regain composure and evaluate why the strategy wasn’t working. The stops protect capital regardless of the reason for underperformance.

It’s also wise to trade multiple strategies to diversify revenue streams. Each new strategy should start small and increase in size as it proves profitable. Once a strategy makes its lifetime stop, the size can increase.

For example, a monthly stop of 5% of capital is a good starting point. If a strategy has made 5% and then starts to underperform, losing 2.5%, the risk is halved. This approach makes it harder to hit the lifetime stop of 5%.

Having a plan in place for when a strategy underperforms ensures long-term effectiveness and capital protection.