You’ve probably read trading articles that talk about how your “winners need to be greater than your losers”, it’s used so much that it’s become cliché. It is NOT as simple as having a series of trades and just keeping your risk at 1r and your average profit objective of 2r, that is never going to be the case in real world trading. There are several situations where maths is applied to trades I personally take that can dramatically increase the risk-reward, which increases the overall risk-reward across a large sample of trades.
I am going to present three ideas on money management involving simple maths that you can apply to your trades right now. After reading today’s lesson, you’re going to walk away with three concepts (One of which you might know and two you probably don’t), that most people rarely talk about or execute in their own trading plan.
Here are the concepts in no particular order: 1. Understanding the risk vs reward profit ratio in your trading. 2. Using winning streaks to ‘reverse martingale or pyramid across trades. 3. Using pyramiding in a single trade position to magnify gains.
This article won’t discuss trade setups in any detail, rather it’s focus is on how simple maths can be applied to your money management. If you don’t have the patience to read and understand this lesson, you certainly are not ready to learn the price action patterns I trade with. Do the work and understand the capital management and position sizing concepts before you start looking for the ‘holy grail trade entry strategy’.
1. The Money Management Cliché We Need to Actually Understand…
Winners need to be bigger than losers.
Sorry to repeat what you already know, but it’s an unavoidable fact that to make money over the long-run, your average winning trade needs to be bigger than your average loser.
In a nutshell, the only way to achieve this is having your risk be small on each trade and your profit objective being larger than your risk, usually two to three times or more. Over time, you will average around 1.5 to 1 and 2 to 1 across a large sample of trades if you’re doing well.
Here is a table that presents 10 hypothetical trades, each with a constant risk of 1r and various targets.
Some trades lost and some trades won, the end result shows the average winner at approx. 2 times the average risk.
Easy as an example but in the real world harder to do obviously. For greater understanding, check out the following articles:
2. Pyramiding in a single trade
The power of snowballing position size inside a single trade..
Pyramiding a trade allows you to ‘snowball’ it into potentially a huge winner by adding to a winning position at predefined intervals. We can turn an initial 1R risk into potentially a huge R profit by adding a new position onto the trade as it moves in our favour, which essentially allows us to trade with the markets money since we are not taking on any new risk. The result is a snowball effect which builds a small trade into a much larger winner if the trade continues in your favour.
For a greater understanding of this, check out this article on pyramiding trades for big profits.
3. Winning trade streaks using ‘reverse martingale’ (something most people never talk about)
Compounding profits across multiple trades…
If you’re in the market long enough you will know when you’re on a winning streak and when a market is ripe for the picking. Yes, that statement is arbitrary to the technical minded and gut feel is definitely applied to this concept.
I am going to discuss this concept at the most basic level to demonstrate the power of applying some fancy yet simple money management maths during winning streaks…
The idea is similar to adding to a winning trade in a single position (as discussed in point 2 above), but in this case, we are doubling and thus compounding our risk per trade across multiple trades. Before I discuss this concept, let me clarify that this is not martingale strategy whereby a trader doubles up on losses, it is in fact, reverse martingale, where a trader uses profits from one trade and re-invests them in the next trade, essentially doubling the position size on the subsequent trade. Basically, we are using the markets money since you are not risking anything over your 1R investment on the first trade.
The idea is simple; we are doing the opposite of standard ‘martingale’ in which a trader would simply continue to double his risk per trade until he wins. Instead, the reverse martingale is a method we apply when we anticipate a streak of wins in optimal market conditions and we then double up our position across multiple trades only if we win the previous trade. This method can supercharge an account, and remember, we are trading with the markets money, not our own!
To demonstrate the maths in this concept, we will place three example trades, all with a risk reward profit objective of 2r, however, the risk will be increased on each trade as the streak plays out, as explained below…
1R risk, to return 2R profit. Trade wins and you earn 2R.
Now you’re in a positive mindset about a trending period in the market and the recent signal that has paid off, so you’re anticipating a streak. You will now do the following…
Re-invest the previous win (2R) on the next trade. Trade wins, you earn 4R.
Now you retain the same view as the prior trade, you’re in a trending period and the signals are working well, you are prepared to roll all of the previous profits (4R) into the 3rd and final trade of the streak…
Risk 4R trade wins, you earn 8R.
Total result of streak
Most risked at any time = 1R
Total return = 8R
8 to 1 total risk / reward)
Here’s table showing our example trades and how the returns double each time we re-invest the previous trade’s winnings:
The above example shows us a brilliant case of using the market’s money and simple maths to trade a small initial risk into a huge return.
Now, I am sure some of you are thinking “How do I know when the streak will occur?” and so on. You don’t know for certain but there are indeed market periods and conditions where the trader with experience knows the likely hood of streaks are higher. Even with a random walk, where you randomly apply this concept of re-investing / compounding profits, you are bound to have some decent wins. This will only improve as your confidence and trading abilities improve over time through proper trading education and experience.
The maths above is incredibly simple, but it’s essential to understand and if understood can literally take your trading results from mediocre to outstanding, very quickly.
These are the very same position sizing and money management techniques that I personally apply to each price action trade setup I execute. These are also the same money management techniques that I teach my students to apply to the price action strategies, all of which is contained within my advanced price action trading course.
Trial the ideas on a demo trading account or if your already trading live, trial the ideas on smaller positions until you perfect the concepts.
Good trading, Nial