Risk-based trading

Risk-based trading is the best method for managing probability and random outcomes.

The trader pre-selects the desired risk amount and then Sizes the position such that the maximum risk stop (if triggered) will not result in a loss greater than the pre-determined risk amount (usually in dollars).

The initial risk amount – either in points or dollars – is referred to as R. Winning trades, following a productive breakout are then allowed to run for a multiple of R.

This is called a ‘Risk-Game’.

This creates a scenario that is referred to in statistical terms as positive expectancy.

The trader is willing to risk 1R with the expectation of profiting 3R or more given random outcomes.

Combined with a low-risk, high-probability trading strategy, success over time is assured.

Once you know how to trade – how to locate the lowest setup-risk trades, entries may be placed in a “context” where 3-5 R (3-5 times risk) is a realistic expected (random) outcome.

The important characteristic of this type of trade management strategy is called a Positive Cumulative Payout.

Simply stated, winners are considerably larger than losses over any trade sample (multiple number of trades).

To analyze the performance of a sample, the trader calculates what is called the profit factor.

The profit factor is simply the aggregate amount of net GAIN divided by the total amount of Loss over a sample of trades (usually 10-20).

Unless you size for risk and play a Risk-Game, you might be using a strategy with a Negative Cumulative Payout.

That is, your winners will be smaller than your losses over any sample.

The majority of options strategies such as spreads and binary options, as well as most short-term FOREX trading systems, offer negative cumulative payouts.

The amount of a loss is considerably larger than a pre-determined winner.

The concept of trading with excessive risk is referred to as an inverted risk skew.

An inverted risk/reward skew may be 3:1 (risk is 3 times the size of reward) or worse.

Over the long-term, successful trading of any security is difficult (if not impossible) with an inverted risk skew.

With risk-based trading, there exists an expected positive risk skew.

Here, the expected risk/reward may be 1:3 (winners are 3 times the size of losers) or more.

Regardless of what or how you trade – ALWAYS ensure your system has the following three (3) qualities:

1. A low-risk, high-probability market entry

2. Positions sized properly for pre-determined risk and a Risk-Game

3. The entry is placed in a Context where Expectancy is 1:3 or greater Now that you understand what Risk-Based trading is all about, you can be certain to incorporate it into your trade strategy to ensure success over time.

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