I trade the Forex markets and record all my trades with the amount risked, amount gained etc. There appears to be a correlation between the success rate of trades (how many are positive out of 10), the amount gained on a sucessful trade (the risk reward ratio) and the amount of the capital risked, and I dont understand why!
Here is the example using hypothetical amounts:-
A trader has a trading account with £1000 in it. He is a consistent trader and for each sucessful trade he makes he doubles his investment. He wins 4 out of every 10 trades he makes. So if he was to risk only 2% (£20) of his capital on each trade he would lose 6*2% = £120 and win 4*4% = £160, so his net gain is £40 for every 10 trades he takes. OK, he is keen to see his capital grow faster so he compounds his wins, but as a measure of safety he also compounds his losses (not sure if the terminology is right here so I'll explain). He starts with £1000 and he knows he is only going to win 4 out of every 10 trades, to keep it simple lets assume he losses 6 in a row then wins 4 in a row. First trade risk is 2% £20 and its a loss so the capital reduces to £980, second trade risk is still 2% but now 2% of £980 i.e. £19.60 and its also a loss so the capital reduces to £960.40 and so on for the first 6 trades. At the end of his 6th trade the capital has reduced to £885.84. He now hits his winning streak of 4 consecutive wins and compounding those wins (this time he makes 4% on each one because his risk reward is always 2 times) at the end of his 10th trade he has increased his capital to £1036.31.
So far so good, now here's the bit I dont understand.
If you use the same calculations but increase the amount risked I would expect the size of the captital at the end of 10 trades to just keep increasing but it doesnt. It peaks at 10% and then falls off again as follows :- risking 9% on each trade givesa capital size after 10 trades of £1100.97, risking 10% gives £1102.00 and risking 11% gives £1100.98.
Interestingly if his sucess rate increases and he wins 5 out of 10 trades the optimum peak percentage risk increases to 25%, for 6 out of 10 its 40%, 7 out of 10 its 55%.
I have modelled this in excel so I'm fairly sure its accurate and the calculations are correct but I just dont understand why the is a peak and then a drop off. I'd be very grateful is someone can explain.
Many thanks
Bill
Here is the example using hypothetical amounts:-
A trader has a trading account with £1000 in it. He is a consistent trader and for each sucessful trade he makes he doubles his investment. He wins 4 out of every 10 trades he makes. So if he was to risk only 2% (£20) of his capital on each trade he would lose 6*2% = £120 and win 4*4% = £160, so his net gain is £40 for every 10 trades he takes. OK, he is keen to see his capital grow faster so he compounds his wins, but as a measure of safety he also compounds his losses (not sure if the terminology is right here so I'll explain). He starts with £1000 and he knows he is only going to win 4 out of every 10 trades, to keep it simple lets assume he losses 6 in a row then wins 4 in a row. First trade risk is 2% £20 and its a loss so the capital reduces to £980, second trade risk is still 2% but now 2% of £980 i.e. £19.60 and its also a loss so the capital reduces to £960.40 and so on for the first 6 trades. At the end of his 6th trade the capital has reduced to £885.84. He now hits his winning streak of 4 consecutive wins and compounding those wins (this time he makes 4% on each one because his risk reward is always 2 times) at the end of his 10th trade he has increased his capital to £1036.31.
So far so good, now here's the bit I dont understand.
If you use the same calculations but increase the amount risked I would expect the size of the captital at the end of 10 trades to just keep increasing but it doesnt. It peaks at 10% and then falls off again as follows :- risking 9% on each trade givesa capital size after 10 trades of £1100.97, risking 10% gives £1102.00 and risking 11% gives £1100.98.
Interestingly if his sucess rate increases and he wins 5 out of 10 trades the optimum peak percentage risk increases to 25%, for 6 out of 10 its 40%, 7 out of 10 its 55%.
I have modelled this in excel so I'm fairly sure its accurate and the calculations are correct but I just dont understand why the is a peak and then a drop off. I'd be very grateful is someone can explain.
Many thanks
Bill