Money Management

This discussion is going to focus on futures trading – but there will be other posts that go into options money management later. These are so very different – we have to keep them separated. When it comes to trading futures, we can very clearly state this fact. There is no doubt or hesitation when I say this; there is no gray area here.

“If you are not in control of your risk to reward you will fail as a futures trader.“
Signet 2020

What is Risk to Reward Ratio

So, what does risk to reward mean and how do we manage it? Risk to Reward (or, RR) is a calculation to determine the ratio of money at risk versus the money anticipated to be made. An RR calculation can be used to look back at trades we have already taken (what I call hRR or historic risk to reward) or it can be used to look at our trading strategy (what I call sRR or strategic risk to reward).

How do we calculate hRR

To calculate an hRR we divide the profit from the loss. This can be done on a single trade or on a collection of trades. If I took a single trade and it was a winner, I can use the stop value for the loss side in the equation or I can use the “heat taken” in the equation. So, if the trade I took made 37.50 points and my stop was 5 points then the calculation for hRR would be 37.50 / 5 = 7.50.

What is 7.50 and how is that a RR of any kind? 7.50 is how many points of profit I made for each point of profit I had at risk. We would say that the hRR was 7.50 to 1 (or 7.50:1). But, since I did not trigger the stop loss in this situation, I could decide to use the heat taken during the trade. Suppose I entered the market at 100.00 and the price pulled back to 98.75 before running up to 137.50 where I exited the trade? This would indicate that I actually really took 1.25 points in risk, not the 5 point stop. 37.50 / 1.25 = 30. The hRR in this equation is 30 to 1 (or 30:1) risk to reward ratio. I prefer to use the stop for my calculations, but either one would be acceptable.

When do we use hRR

So, why would we want to calculate our hRR? Our trading strategies are designed to keep us within a profitable trading path – and although we may tag the edges of that strategy once in a while, we should be within the boundaries of our strategy “on average.” If my strategy is designed for a 5:1 risk reward ratio but I am constantly closing my trade below that profit target – I am not hitting my goals in the strategy and something should be examined for changes. We can also use the hRR to make a decision about a trading strategy. If the strategy is traded on paper and can not produce a profitable hRR for the win rate of the strategy, then something has to change.

When do we use sRR

What is sRR used for? When we develop a trading strategy it has to be profitable within the win rate. “Winning” frequently is not how we profit in the market; winning more money than we lose is how we profit in the market. The only thing under our control is the sRR. We determine the stop size and we determine the target profit.

When I first start trading a new strategy, I use a paper account without a stop and I trade the strategy for 100x. At the end of that, I use Tradovate Statistics to show me the “avg heat” per trade and the average win per trade and I make a decision about the stop at this point. If the profit is great enough to cover the heat 5x and I am comfortable with the size of that stop, I build a bracket order using that stop size and I trade the strategy another 100x with that stop to see what type of win rate the strategy generates.

How to calculate the sRR

To calculate the sRR we first need to determine what the profit target should be. To calculate what the profit target should be we take the stop and multiply that by our desired RR. I really like using a 5:1 RR and so to determine a target profit with a 5:1 RR I would take my stop size and multiply that by 5. In the Globex, I frequently trade the NASDAQ with a 2-point stop. For a 5:1 RR i would take that 2-point stop and multiply by 5 (2*5 = 10). My profit target needs to be at least 10 points if I want to use a 2-point stop.

If the trade I want to take does not offer me “room” to reach my target profit zone without offering me resistance – I know that I can not enter the trade. In the picture below, I demonstrate what a “no trade” entry looks like. In the intraday I like to use a 5 point stop and a 5:1 sRR which means I need a clear path to 25 points profit. If I am looking for an entry at $13750 with a 5-point stop then I need to have a clear path to $13775 target profit. The picture shows that there is a lot of resistance between my entry and the target – it would not be a good trade to take with that stop size.

How to adjust the sRR

In the picture above there is a 12-point wide range – this is tradable and we could decide to place a trade here but we need to know what size of a stop to use while keeping my 5:1 sRR. We can not really expect to take the whole 12-points, but maybe we can take 10 points? To calculate this sRR we divide the target profit (10-points) by the sRR value (5) and the answer is our stop. 10/5= 2. So, if we want to trade this range, we need to use a stop of 2-points or less. We can always choose to use a smaller stop than the strategy suggests.

Trading Stats

Now that you know how to calculate a risk to reward for your strategies and you know how to calculate a risk to reward for the trades you have been taking, go back and look over your history and look at your results. Keep track of them – and work to increase the size of the RR. I update my stats on a monthly basis and everything is recorded. Below is the trading stats for May – the day I am writing this is the last trading day in May and this is a good time to do what I call “house keeping.”

| Stop $100 | Max DrawDown $3.03 | Max RunUp $1,605 | Total Profit $1,600.74 | hRR 16 |

A short video that I made discussing RR stats and how important it is to focus on the RR rather than focus on the win rate.

How much account should I use in a trade? Lets have that discussion!