Over Christmas I digested a few trend following investment books. I found the O'Neil CANSLIM bible to be very interesting, particularly the lessons on entering on reduced volatility pullbacks and relative strength metrics across the market and higher timeframes (weekly with daily).
Following on similar themes,and again very useful and interesting, was Minervini "Trade Like a Stock Market Wizard". Perhaps a bit too much hype at times, but I found myself re-reading his section on risk over and over. Now I've read (and thought I understood) the need for risk control, stops and what Brooks calls "a positive trader's equation". Minervini seemed to get through to me where others have failed.
The penny dropped one day when I realised I was making a fundamental beginners probability error. If you have 3 winning trades interspersed with 3 losing trades, each winning and losing the same amount (say 50%) you end up even? WRONG, of course! The probability for each event is multiplied not added. If you lose 50%, it takes more than 50% to get that back.
Minervini firmly recommended a value of 7.5% maximum risk, particularly for traders with less than 50% winning trades (he calls this the "batting average"). Wanting to explore this further I did a series of spreadsheet pages on what happens when you have 10 consecutive trades with increasing probabilities of gain and loss.
Below is a plot for 2:1 win/loss for "batting averages" from 25% to 55%. Total predicted return after 10 trades is on the Y Axis in %. The optimal return after 10 trades is not intuitive (to me!). Minervini is quite right to suggest trend trading beginners, frequently only achieving 40-45% batting averages, should stringently aim for losses to never exceed 7.5% - which easily ends up at 10% in real life.
Similar plots are possible of course for different win/loss ratios - this is only a summary for the specific situation of win/loss = 2. I'd be happy to put the spreadsheet up for general reference and people to check if all this babble interests anyone!
The take home lesson for me is what experienced traders have learned the hard way and know intuitively - and try to bang into our beginner heads all the times! That is, stringently contain your losses, but aim to let your winners run (or at least regularly exceed losses).
Expectancy and Risk two to one win loss ratio.jpg