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Trader's equation based on actual risk or initial risk?
I believe we should base our Trader's Equation calculations based on initial risk and not actual risk. The reason is that we don't tighten our stops if the market goes sideways right after entering. The premise could still be valid until the stop is hit, and hence there is no real clue to tighten the stop and reduce the actual risk on the trade. So, on losing trades we're using actual risk, and on winning trades, we're fooling ourselves by thinking that we've made many multiples of actual risk, whereas, in reality, the profits are 1-2x the initial risk.
Can someone clarify if this is right?
I don't know about the math which way is correct but from experience of trade management, I'd say we don't let our full stop get hit (initial risk) right? Maybe the only exception is a swing setup where the stop is small and it goes against our entry immediately after triggering. But again, also most swing setups, result in either big win, small loss or more or less break even, so the average loss is < than initial risk.
Good example is AI or break out trading, where the stop is big (initial risk), if the follow through is really bad and disappointing I think most will be able to exit around half loss (-0.5R). Only 10-20% of the time your full initial risk stop gets hit. Again, from experience, in this style most of my winners are 0.6R and losses around 0.4 to 0.5R, with probability around 65% it is a profitable strategy.
TLDR: actual risk makes sense in active trade management context
So, on losing trades we're using actual risk, and on winning trades, we're fooling ourselves by thinking that we've made many multiples of actual risk, whereas, in reality, the profits are 1-2x the initial risk.
Just a correction, I meant to say, we're using initial risk on losing trades and actual risk on winning trades.
@yuri Yes, it makes sense if we adjust stops on both winning and losing trades. As a beginner, I'd like to leave the stops and profit targets alone and let the trades work. This is primarily because I want to make fewer decisions starting out and start adjusting stops only after I feel comfortable due to experience in the markets.
Regardless, I think the strategies are profitable even if we use initial risk on both winning and losing trades.