Author: VictorWong   |   Latest post: Thu, 24 Jan 2019, 10:46 AM



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Frequency of Winning x Average Size of Win) - (Frequency of Losing x Average Size of Loser) = Risk 
(.40 x 3) - (.60 x 1) = (1.2 - .6) = .6 Risk Unit...Trading is about math and risk management...The gist of the model is that you must keep your losses small and let your winners run. Indeed, many successful traders target a 3:1 or 4:1 relationship between winning trade profits and losing trade losses. 
Say you begin testing your trading rules, and you see they win with a frequency of 40%. In other words, you are wrong more than half the time. You also notice that your winners are three times the size of your losers. Should you follow this model or not? How are you going to make money if you're wrong 60% of the time? What will your friends say? Worse, what will your spouse say? All of this chatter is part of your emotional system that can be calmed down by taking a look at the math. 

Here's how: 

(Frequency of Winning x Average Size of Win) - (Frequency of Losing x Average Size of Loser) = Risk 
(.40 x 3) - (.60 x 1) = (1.2 - .6) = .6 Risk Unit 

The Mathematical Expectation formula shows that you can have confidence following your trading model because "on average" the rules make money (i.e., the formula’s result is a positive number) even though you lose more frequently than you win. 

It's important to note that it's the combination of keeping your losers small and letting your winners run that makes this work. You can’t "wait and see" if your losers will come back to become large winners. That happens between rarely and never. If you're an investor, that might be a different story, but we're keeping this discussion to trading leveraged instruments in commodity futures . 

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