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Thursday, February 3, 2011

VAR, Risk / Reward ratio and money management

A positive risk/reward ratio is the heart of a successful trading.

Some thoughts derived from the yesterday possible trades.

The trades:
  1. sell @ 1.3830, risk/reward (r/r) = 0.42 (losing 30 pips, gaining 70pips), closed @ 1.3780, 50 pips gain
  2. sell @ 1.3805, r/r ratio = 0.28 (risking 10 pips, gaining 35), stopped out @ 1.3815, 10 pips loss

Total: 40 pips gain

Put that way the above figures mean almost nothing because they don't translate into real money. How they will translate depends greatly on the invested amount and its portion of your whole portfolio. So if you decide to put 5% of your portfolio in a deal and risk it, basically that's your Value at Risk (VAR). In general the greater the VAR, the faster the movement of your account (growing or vanishing). If you decide to have a VAR of 50% in a simple move you might double the account or zero it.

Let's say you are willing to risk 5% of your capital (your whole portfolio). The VAR is 5%. Simply this means that you might have 20 wrong trades in a row before you zero out your account. So if you want to have a greater number of tries, lower the risked amount. 1% VAR = 100 wrong trades in a row.

Where is the risk/reward ratio here? The risk/reward rule basically says that the amount of profit you expect from a deal should be greater than the amount you are willing to risk! As we deal with future events that ratio happens to be an imaginary variable strongly dependent on our own ability to successfully expect the correct future events! Thus the risk/reward ratio is often used to distinguish between possible bad and good deals.

Both the value of VAR and the risk/reward ratio have a direct impact on the level of stops you choose. Let's look again at the examples above. In the first trade the possible loss in pips was set to 30 by the stop being 30 pips away from the entry level. If the account was of $1000 and the player was willing to risk 5% of it that would translate to a possible loss of $50. $50 loss for 30 pips is achievable by trading almost $16500 which means the player had to open a position of $16500. The important point is that the player has chosen that deal because he or she is expecting the gain from the trade to be bigger than the possible loss.

The level of the stop could vary depending on the expectations of the player but if the value of VAR stays the same all other variables could be changed accordingly bearing the same risk (measured by the amount of possible loss) to the portfolio. It doesn't matter if you trade a position of $33000 and put a 15 pips stop-loss or a position of $16500 and 30 pips stop-loss. The VAR in both cases is $50. What changes is the probability of successfully striking your stop with the relation being that closer stops get hit more often. That probability could shorten the life-span of your account which means that in general the wider the stop, the better.

Combining winning and losing deals which have had a positive risk/reward ratio the player might successfully manage the growth of his or her account.

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