Today’s article is about a seemingly obvious concept; how to measure trading profits. Yet, most traders start out measuring their profit (and loss) totally wrong, but it’s really not their fault. Conventional thinking and what is typically spread on the internet or recommended by brokers and even in many books, just isn’t how actual professional traders think about measuring trading performance or managing risk (they go hand-in-hand).
Hence, today, I want to give you a real-world lesson which is probably not what you have read or heard elsewhere, on how to properly measure your trading performance and risk in the market. After all, this is a pretty core-component to your trading career, and if you don’t have this part down how can you expect to actually make money in the market? I think you agree.
As you know if you’ve followed my blog for any length of time, I am primarily a swing trader and that is the style of trading we focus on here and that I teach my students. Why is that important? Well, because depending on how you are trading, you will want to measure your profits differently, and for swing traders like you and I, there is one way to measure profits that is clearly more logical and simply “better” than the rest.
However, before we get into how I measure risk and reward as I trade the markets, let’s be fair and transparent and go over the three primary ways traders measure this. We will discuss each of them and then I will explain which one most professional traders focus on, and why.
The 3 Primary Means of Measuring Profits:
- The “2%” Method – A trader picks a percentage of their account to risk per trade (usually 2 or 3%) and sticks with that risk percentage no matter what. The basic idea here is that as a trader wins, they will gradually increase their position size in a natural way relative to account size. However, what usually happens is traders lose (for a number of reasons discussed in my other articles, check out this lesson on why traders fail for more), and then they are stuck trading smaller and smaller position sizes due to the 2% rule (the 2% means less money risked as you lose), making it harder just to get back to their starting amount, let alone actually make money!
- Measuring Pips or Points – A trader is focused on pips or points gained or lost per trade. We aren’t going to focus much on this method because it is so ridiculous. Trading is a game of winning and losing money, not points or pips, so the idea that focusing on the pips will somehow improve your performance by making you less aware of the money, is just silly. You will always be aware of the money, no matter what. Only by properly controlling your risk per trade can you control your emotions, and that means you need to know what you are risking per trade in monetary form (dollars, pounds, yen, etc).
- Measuring based on “R” or Fixed $ Risk – A trader predetermines how much money they are comfortable with potentially losing per trade and risks that same amount on every trade until they decide to change that dollar amount. The dollar amount they are risking per trade is known as “R” where R = Risk. Reward is measured in multiples of Risk, so a 2R reward is 2 times R, etc. Yes, there is some discretion involved with this method, but honestly, discretion and gut feel in trading is a big part of what separates the winners from the losers. I will explain more as you read on…
Fact: Size doesn’t matter.
A recent study I read on what women thought was the most important feature of a man…joking! Lol. Seriously though…
Trading account size really doesn’t matter in regards to trading performance. For example, a trader with a $1,000 account might be a much better chart technician and have more self-control than a trader with a $100,000 account. So whilst the trader with the smaller account is making money and having a great trading year, the trader with the big account is losing and losing large sums of money most likely. The point is; simply having more money doesn’t make you a better trader!
In Forex, account size is truly arbitrary because a Forex account is simply a margin account, which means it’s only there to hold a deposit on a leveraged position. Any trader who understands these facts would never put ALL their trading money in their trading account because it is simply not necessary and is not as safe or lucrative as holding that money elsewhere.
The amount you fund your trading account with does not necessarily reflect all the income you have to trade and it does not reflect your overall net worth. However, in stock trading, you need a lot more money on deposit because there is less available leverage. Typically, if you want to control 100k worth of stock you need to have 100k in your account. Forex is much more leveraged as I’ve already said, and this means that to control say 100k of currency, which is 1 standard lot, you only need around $5,000 in your trading account.
Another example to help you understand this is; imagine a “rich guy” who only puts $1,000 into his account vs. a “poorer” guy who puts his entire $10,000 net worth into his trading account. Would the rich guy risk 2% and the poor guy risk 2%? Of course not! The point is that it’s really random to suggest these two traders would both risk 2% of their account balances because the account balance doesn’t take into account all factors. Risk per trade has to be a deeper thought process, it has to be personal based on circumstances and the entire risk profile and financial position of the trader.
The fixed $ risk model makes sense for professional traders who want to derive a real income from their trading; it’s how I trade and it’s how many others I know trade. Pro traders actually withdrawal their profits from their trading account each month, their account then goes back to its “baseline” level.
How much should you actually Risk per trade?
Ok, so by now you might be thinking “Nial, how do I know how much I should risk per trade?”
The answer is much less complex than what you might think. I believe in determining a dollar amount that you are comfortable with losing on any one trade, and sticking to that dollar amount at least until you have doubled or tripled your account, at which time you can consider increasing it.
This amount should be an amount that satisfies the following requirements:
- When risking this dollar amount, you can sleep sound at night without worrying about trades or checking on them from your phone or other device.
- When risking this dollar amount, you are not glued to your computer screens becoming emotional at every tick for or against your position.
- When risking this amount, you should be able to almost ‘forget’ about your trade for a day or two at a time if you have to…and NOT be surprised by the outcome when you check on your trade again. Think, ‘set and forget‘.
- When risking this amount, you should be able to comfortably take 10 consecutive losses as a buffer, without experiencing significant emotional or financial pain. Not that you would IF you’ve mastered an effective trading strategy like my 3 core price action patterns, but it’s important you allow that much buffer for psychological reasons.
Fixed $ Risk vs. % Risk
If you’ve read my other articles on this topic, I have argued for the fixed dollar risk model and against the 2% rule, but in case you missed that lesson, I want to discuss again why I prefer the former to the latter…
The main argument I make about this topic is that although the 2% rule will grow an account relatively quickly when a trader hits a series of winners, it actually slows account growth after a trader hits a series of losers, and makes it very difficult to bring the account back up to where it previously stood.
This is because with the % R risk model you trade fewer lots as your account value decreases, while this can be good to limit losses, it also essentially puts you in a rut that is very hard to get out of. For example, if you draw down 50% of $10,000, you are at $5,000, and to get back to $10,000 you have to make 100% return, it’s a long way back to break even and then profitability using the 2% rule, because you are effectively trading a much smaller position size once you draw down that far.
This is why I say the 2% model basically leads a trader to “death by one thousand cuts”, because they tend to just lose slowly as the position size shrinks after each loss. It deflates their confidence and they end up over-trading because traders begin to think “Since my position size is decreasing on every trade it’s OK if I trade more often”…and whilst they may not think exactly that…it is often what happens.
I personally believe the % R model makes traders lazy…it makes them take setups that they otherwise wouldn’t…because they are now risking less money per trade they don’t value that money as much…it’s human nature.
Conclusion…
If you only remember one thing from this lesson, remember that the most logical way for a trader with an effective trading edge to measure trading performance or (profits) is the fixed risk or R model.
Whilst I do not recommend traders use the “2% rule” or a fixed % model, I DO recommend that you risk a dollar amount you are totally comfortable with losing on any given trade. Remember, you never know which trade will lose and which will win over any series of trades, so it’s foolish to jack up your risk on a certain trade just because you “feel” more confident about it. If the amount you’re risking per trade is keeping you awake / unable to fall asleep at night, you are risking too much, so dial it down.
Please Leave A Comment Below With Your Thoughts On This Lesson…
