# Risk Management III

BarroMetrics Views: Risk Management III

I asked Baz the question in yesterday’s blog because most newbies focus on a high win rate. But, to produce a consistent profit, successful traders know that this is only one part of the success equation,  the other is the Average Dollar Win/Loss. And this leads me to the final context needed to answer Baz’s question:

Our profitability is governed by:

• Our expectancy return and
• Where we are in the Ebb-Flow Continuum

Our success is measured by expectancy return. In turn our expectancy per trader is derived from the formula:

(Average\$Win x WinRate) – (Average\$Loss x Loss Rate) = + Result

An implication of the formula is that a high win rate can lead to negative result: because the Avg\$Win is too low and/or the Avg\$Loss is too high for the Win Rate.

For example, plugging in the numbers below to the formula:

(1.00 x .90) – (100 x . 1) = – \$0.10

High Win Rate with a negative expectancy result

Now, the Win Rate is less within our control than the Avg\$Win. I see the Win Rate as governed by how well current market conditions suit our trading plan. And how well our plan fits is reflected by the Ebb-Flow Continuum.

There are times when our plan suits market conditions to a ‘T” – under these conditions, we’ll have a high win rate. Everything we do turns as as we expect.  We are ‘God’s gift to the trading world’ the flow stage. The Ebb Stage is the reverse: everything we do disappoints our expectations. Our Win Rate plummets.

The successful traders I know have tools to recognise the two stages, plan and position sizing  strategies appropriate to the cycle stage.

The reason why so many traders fail is because they fail to recognise or are unaware of Ebb & Flow – they continually blow up in Ebb Phase. This assumes, of course, that they have a plan that has a positive expectancy in the Normal Phase. This is the phase that we usually find ourselves. Win some, lose sum and return a positive expectancy.

We return a positive expectancy because, given our Win Rate, our Avg\$Win is greater than our Avg\$Loss. This is a function of the robustness of our plan and how well we execute it.  The latter is totally within our control.

And this leads me to the elements of a robust trading plan – the answer to Baz’s question.

## 4 thoughts on “Risk Management III”

1. Baz says:

Thank you Ray, you hit the nail on the head, Ebb and Flow. My sample size was still too small but it had 94% win rate and positive expectancy number but the sample size was only about 60 trades.From the numbers whilst positive,i could see it wouldnt take much of an ebb to be negative.I also was thinking what factors determine the ebb or the flow. I know from gambling ,Blackjack when your hot you can push it abit. but how can you measure luck or determine when it will occur.I came up with timeframes and currency strength. Maybe when i finish my trade plan,could you have a perusal?over a beer? thanks for help cheers Baz

2. Paul says:

hi Baz,
1. To me,
(Average\$Win x WinRate) – (Average\$Loss x Loss Rate)

is meaningful only if your Average\$Win & Average\$Loss are constant!

2. For Blackjack, it is truly a probaility game
– there are only a certain number of cards, Kings, Queens …
– It is a calculated risk game

– Nothing is certain

3. Haha, how to measure/determine ebb/flow state?

4. What should be the trade size strategies during the ebb/flow state?

3. Baz says:

What i was trying to achieve was develop a new trading system. I am very much aware that high win rate doesnt necessarily equate to a successful system, thats why i turned to the Expectancy Formula to measure its performance.After watching one of Rays videos , where a brokers report was discussed, about ‘S’curve and vision statement of the successful traders.It motivated me to reappraise.Subject matter that was once given scant attention has taken on new meaning and understanding.Whatever the common denominator is that the successful 5% do, Im going to do it, some i already do but can do better or brush up on.To some degree i already have been successful but i love learning new things and techniques. Rays story is also very motivating too. thankyou cheers Baz

4. Paul says:

hi Baz,
For your info, during a presentation by Ray in Nov 2012, he said his returns would greatly improved with a certain trade size strategy.

Cheers!

Paul