Eliminating and Postponing Risk, Two Very Different Things

When you start to design a trading system for forex trading you soon realize that there are many tactics you can use to make a system easier to trade – lower its pain index – and make the system seem more attractive in the short or medium term for investors. Many of these tactics involve modifications of the money management aspects of the system (lot sizes plus exit logic) which generally attempt to make systems have a higher probability to reach new equity highs. Generally this is achieved through the use of progressive money management systems (Martingales, D’Alemberts, etc) or through the increase of the risk to reward ratio such that reaching a profitable outcome becomes much more likely. However when you use these tactics you do NOT increase the profitability of a strategy but you merely postpone and even increase risk. On today’s article I will talk to you about the difference between postponing and reducing risk and how you can develop strategies making sure that you reduce risk and NOT just postpone it to a later date.

Certainly people have realized very quickly that when entering a single trade the probability to reach the TP increases linearly as the TP is moved closer to the entry and the SL is moved further away. The larger the SL to TP ratio is the easier it will be for a trading strategy to achieve a profit within a single trade. This is an obvious conclusion since price is bound to reach shorter take profit values merely through the random distribution of price levels around the entry and the further away the stop loss is the harder this process will be for an unfavorable outcome. Overall – when talking about single entries – having a short TP and a huge SL gives a very high probability that a trade will have a profitable outcome.

The problem comes when we realize that the mathematical expectancy of any given entry logic remains the same, regardless of the values of the TP and the SL. This means that in the long term the gross amount of lost money will remain fairly constant – or increase – independent of the values of the TP and the SL. These means that if you have a 1:500 reward to risk ratio you will have a high probability to reach profit on each trade but in the long term the gross amount of money lost will be paid through the reaching of a few Stop loss values. If the mathematical expectancy of the system is positive the final outcome might still be profitable but if the initial mathematical expectancy is negative the outcome will certainly be negative even if there are long periods of profitability caused by the small change of hitting a losing trade.  So in effect what we are doing when we use unfavorable risk to reward ratios is nothing but postponing the cashing of the systems’ market exposure. A system that has no statistical edge might show significant periods of profitability shown by sharp losses that wipe the account while systems with a positive mathematical expectancy might show sharp draw downs that will eliminate a very large part of the system’s profitability.

A similar logic applies to progressive money management. When you increase lot sizes after losses you are increasing the probability to reach a new equity high by assuming that a winning trade will come before an equity wipe out happens. However this logic is only true if the probability to reach a profitable trade increases with each losing trade something that does not happen with trading since the distribution of returns is usually random. This indeed makes you reach new equity highs more frequently by postponing your market exposure until the time where a random series of losses will reach the point where your account will be wiped. This will be true for every system since the probability to have a winning trade does not increase as the number of losses becomes higher. Systems with a positive mathematical expectancy will still be wiped under a martingale due to the random distribution of returns.

It has always been evident to me that the above mentioned tactics are the “lazy way” to make a trading system seem far more attractive and profitable than what it really is. It makes systems show big profits and small draw downs through apparently long periods of time, only postponing the time when the market will cash the system’s exposure. Generally the above tactics are ideal for selling a system or for making a system attractive to new traders since it shows very “consistent” equity curves with mild periods of draw down. This is a mirage that will end with the traders in tears as it has happened countless times.

In order to develop systems that do not simply “sweep risk under the carpet” – only to be found later – but that actually reduce the risk a system is taking in the long term you need to develop trading tactics that reduce the system’s exposure to the market by deeply analyzing the trading strategy used and applying sound trading principles. The old philosophy of cutting your losses short and letting your profits run is what traders apply most frequently to come up with exit logic and lot sizing techniques that reduce their overall exposure to the market. The idea is to make the strategy more robust to a large variety of market conditions by increasing the overall profitability of trades in the long term, while reducing their losing character and not simply artificially increasing the probabilities to have profitable outcomes on single trades or the ability to reach new equity highs through very unsound trading tactics.

However the first thing that you need to take into account when you develop a system is the mathematical expectancy of the entry logic and whether or not there is the existence of a statistical edge. Many new traders develop systems without ANY statistical analysis, often wasting years in the development of strategies that could have been easily discarded through a long term analysis of its entries. The first thing you need to ensure is that your strategy possesses an edge and after this you need to make sure that your edge is polished through the implementation of exit criteria that will affect losing trades significantly while only affecting profitable trades to a small extent.

In my experience the failure to do rigorous statistical analysis, perform reliable simulations and come up with strategies that tackle simple, yet basic market inefficiencies is what leads people to build strategies with progressive money management and unsound risk to reward ratios. This is the laziest, most dangerous and ineffective way to “reduce” a strategy’s risk and increase its profitability since what you are doing is merely postponing the cashing of the system’s market exposure, meaning that you will eventually face a very nasty scenario due to the overall lack of initial analysis and effort.

If you would like to learn more about system design and development and how you can design and trade strategies based on sound trading tactics please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach automated trading in general . I hope you enjoyed this article ! :o)

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2 Responses to “Eliminating and Postponing Risk, Two Very Different Things”

  1. Chris says:

    Daniel-

    Interesting post and as always great food for thought.

    Instead of reducing the TP to increase the % winners (which does indeed postpone risk until a later date) what do you think about trading more agressively at smaller $ amounts, and progressing to a lower risk profile at larger dollar amounts?

    Sure, it doesn’t change the mathematical expectancy of the system, but it clearly does change the risk/reward profile in a manner which is proportional to my tolerance for risk based more or less on my age. The idea being that when i’m young, i’m more able to accept risk since I have more time to get it back if I lose, and reduces risk when i’m old and have less time to make it back.

    I’m not asking you to add a “years to retirement” parameter to your EA’s. I’m just asking you to consider that fact that at a low dollar amount, adding a martingale element to you systems that if properly managed over time can greatly improve the returns while managing the risks.

    I know you are a purist about these issues, and i’m not asking for a quick ruling one way or the other. But think about the fact that most professional retirement account advisors start out agressive and gradually move toward a more conservative approach highlights the merits of this approach.

    Thanks as always for the great work and keep it coming,

    Chris

  2. admin says:

    Hello Chris,

    Thank you very much for your comment :o) I do agree with you in that younger investors will be able to take more aggressive risks “easier” due to the fact that they have a much longer time to recover any possible losses and therefore the consequences of losing are not very important while for older investors the opposite is true.

    However it is also true that “larger risk” does not necessarily imply unsound trading. For me taking more risk is simply aiming for a higher yearly return and a higher maximum draw down but keeping the trading techniques used sound. I am a “purist” regarding this in the sense that no one has achieved long term profitability through martingales or such unsound techniques and before anybody does, it is clear – as ti has been through countless examples – that these techniques are not just “more risky” they are going to wipe your account.

    In the end I believe that there is a big difference between taking more risks and taking bad decisions. Trading a system that has unsound money management is a gamble while trading a system with sound trading techniques at a higher account risk level is simply increasing your expectancy for profits and draw downs (therefore increasing risk). So I believe you should increase risk without making your trading techniques unsound and prone to total account losses. If you think about this in the long term the longer you can hold into a dollar when you are very young, the larger amount of capital that dollar will represent in the future.

    As I have said a few times, the old saying holds true. There are old and bold traders but there are no old bold traders. Thank you very much again for your comment Chris :o)

    Best Regards,

    Daniel

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