The Numbers Game

To be a successful trader, one must overcome a simple (yet somehow difficult to many) problem, innumeracy. Without understanding the basic concepts of probability, chance and randomness... a trader is fatally ill-equipped.

Assume that EUR/USD is at 1.3900... and there's a 50% chance that it will go up during the Asian session and there's a 50% chance that it will go up during the New York session. To the ill-equipped, it would be easy to then deduce that the chance that EUR/USD would go up during the trading day is 100% certain. Now, to the informed trader... this is clearly not the case. Someone who doesn't understand probabilities is sure to lose money trading.

(Note: In case you haven't figured it out, the chance of EUR/USD going up is still 50%).

Let's take another example. Assume that GBP/USD is at 1.6480. What's the chance of it going up... and what's the chance it would go down? If it were a completely random process with two outcomes, like a coin toss for instance, it would be 50-50.

However, if I had told you that 1.6480 was 10 pips below the Daily R1, this would no longer be the case... for I've now introduced the concept of "the player's edge" or positive expectation. Unless prices blow past the Daily R1 in a strong trend, below the Daily R1 shorts (targeting the Daily PP) outperform longs by approximately 58% to 42%.

Having a sound trading strategy that gives you an edge lets you win more often than you lose over a period of time! Though somewhat crude, a strategy based on price action using pivot points is fairly robust. John L. Person, author of Forex Conquered: High Probability Systems and Strategies for Active Traders (Wiley Trading) describes pivot points as "the best “right side” of the chart indicator... due to its predictive accuracy." They work simply because many individual traders use and trust them, including bank and institutional traders.

With a good strategy, good money management takes one's trading to a completely different level... as you will be able to make more money from your edge and minimize losses.

A good trader's daily-at-risk is typically 2-4% of his equity. Mine is 3%, and this is further divided by ten (10) making my risk per trade at 0.3%. On a USD1 million account, the daily-at-risk is USD30,000 and the risk per trade is USD3,000. Allowing for a 30 pip stop-loss, I'm able to trade a maximum of 10 full lots per trade (USD100 per pip).

The first goal of money management is to ensure survival. Going out of business, i.e. blowing one's account is simply not an option for a professional trader. By having the abovementioned money management settings, I will be able to withstand 10 consecutive losing trades in a day before I have to step away from trading and regroup. Plus, I've the comfort of knowing that a 3.09% gain the next day will erase that loss.

Minimizing losses is key for the deeper one falls, the more slippery the hole becomes. As we have seen, a 3% loss only requires a gain of 3.09% to recoup that loss. A 20% loss on the other hand will require a 25% gain to recoup the loss, and a 50% loss will require a 100% gain to recoup the loss. Remember, whilst losses grow arithmetically... profits required to recoup losses grow geometrically!

The combination of one's trading edge (positive expectations) and sound money management is formidable.

Being on "the right side" of the pivot level, the reward:risk is conservatively 90 pips : 30 pips (3 : 1). Assuming one trades 5 pairs like I do (Cable, Euro, Euppy, Geppy & Chunnel), 20 trades per day is 4 trades per pair per day... which is reasonable. Let's look at a sequence of trades (ignoring the added complication of multi-lots based on bias):

L -30
L -30
W +90
W +90
L -30
W +90
L -30
L -30
W +90
L -30
W +90
L -30
L -30
L -30
L -30
W +90
W +90
L -30
W +90
L -30

Total = 360 pips (8 wins, 12 losses for a 40% win-rate)

Interesting stuff, huh?!! :-)

3 comments:

grask said...

Minibahn, once again thank you for your help, for sharing your methods and thoughts, it's pure gold ;) Thanks, your the man! Keep it up!

Sameer said...

Very intresting... keep it coming.. Thanks :D

Blogger said...

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Fixed Ratio Money Management

It's been a while since I last blogged about Money Management, what many consider to be the most important yet overlooked subject in trading. As one of the three (3) pillars of trading success (the other two being Mind and Method), I therefore feel that I have an obligation to share more of my thoughts on the matter.

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