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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.
Al mentions that it is a good trader's equation to take profits on 1x or 2x actual risk however I'm confused since position size can only be calculated off of initial risk (actual risk is hindsight). So if I exit on actual risk being 2x my actual profit may only end up being something like 0.5x depending on how wide my stops are. If I'm exiting early at 2x actual risk and avg only around 0.5x but losing 1x when my stops are hit, how is this a profitable exit strategy?
I'm probably missing something here but actual risk just seems like hindsight trading to me
As a quick follow up, I know Al says that it is reasonable but often not the most ideal exit but still my hang up is on the reasonable portion of the claim. Seems like you take small winners often and full losers in this scenario
I have been always confused by this as well, so I usually do everything in initial risk and don't worry about actual risk. If I am not moving my stop, till my profit target is hit anyways, I don't have to worry about actual risk.
I do believe taking profits on a multiple of actual risk makes good math because doing so increases probability.
The 3 variables when structuring a mathematically rational trade are Risk, Reward, and Probability.
The smaller the distance your profit taking limit order is to your entry compared to your stop loss order, the higher the probability of your trade.
When combining the correct stop with taking profits using actual risk; and assessing probability by reading the price action, you are taking higher probability trades and so to have a positive trader's equation you need to win 75% or more of the time for it to make sense
One can further increase their traders equation through active management in multiple ways.
SP, Al says the 3 things a trader needs to be good at to be a consistently profitable trader are: 1. Read price action 2. Structure Mathematically Rational Trades. 3. Management of those trades.
By choosing to set the trades and walk away with each one you are not working on trade management.
walk away with each one you are not working on trade management.
But he also talks about the Walmart trade 🙂 - take a reasonable swing entry, set your profit and stop loss and walk away.
I think it depends on what personality you have, where you are in your trading journey.
The trader equation is based primarily on the actual risk which is the minimum, of course you can structure your trade based on the initial risk, but the decision of which to use depends on the context and momentum.
The market is forming a trading range at the opening whose size is less than 25% of the average daily range? so probably when the market is always in mode you will get 2 or more times the initial risk.
The market started a trend from the open, but you entered a little late and had to set the stop far away? then it is probably better to try to look for 1x-2x times the actual risk because 50% the strong moves on the open fails. Or you can scalp out part for two times actual risk and swing the balance until a midday reversal or until the close.
You entered in breakout phase, market is clear always in, big bars, no shadows or overlap, you going use a wide stop right? you can look for 1x time initial risk because is a high probability trade. Think about it, after this breakout the price pullbacks 50%, so two times your actual risk (50%) is equal your initial risk.
You can only know the actual risk in hindsight, after the price goes against your stop.