One of the fundamentals that every trader must know is how to evaluate the effectiveness of his trading methodology. In this article, we will explore core trading fundamentals that you must follow in order to survive and thrive in this business.
1. Never open a position without knowing the initial risk that you are willing to take. The initial risk is the point at which you will get out of the position to preserve your capital.
Very few people have the psychological makeup to keep a mental stop loss and respect it 100%, that’s why for the rest of us, there is the stop-loss that will automatically close our trade for us at a certain level.
2. Define your profit and loss in your trades as multiples of your initial risk.
These are the R multiples. If your risk is $1000 and you make $3000, you have a 3R win. If your risk is $1000 and you lose $1200, then you have a 1.2R loss. You must start to think in terms of risk/reward.
3. Limit your losses to 1R or less. If you don’t respect the stop loss that you have set and let a losing trade run then you are in real trouble.
This mechanism produces 4R losses or larger and can turn your great system into a losing system very easily.
4. Make sure that your profits, on average, are larger than 1R. Let’s say you have one 5R profit and four 1R losses.
If you add those up you have 5R in profit and 4R in losses, a net gain of 1R. Even though you lost money 80% of your trades, you still made money overall because your average gain was big. This is the power of having an average gain larger than 1R.
What is typically known as the golden rule of trading is a summary of these 4 rules:
“Cut your losses short and let your profits run.”
Here we are talking about doing your best to make sure your losses are 1R or less and that your profits are much bigger than 1R. In 2002, the Nobel prize for Economics was awarded to Daniel Kahneman, a psychologist and economist Amos Tversky for their development of “prospect theory”. This theory when applied to trading/investing showed that people have a natural bias to cut profit short and let their losses run, exactly opposite to the golden rule.
5. Understand your trading system in terms of mean (the average R) and the standard deviation (variability in the results) of your R multiples.
Your system, when you trade it, will generate a number of trades. The result of those trades can be expressed as a multiple of your initial risk or a set of R-multiples. You should know the properties of that distribution for any system that you plan to trade. And the majority of the people who trade the markets never know this. If you spend some time and calculate the mean and the standard deviation of your R multiples, you’ll know a lot about your system and what can you expect from it in the long run.