Firstly, lets consider our strike rate. For anyone who does not know what a strike rate is, it is a ratio of the profitable trades divided by our total trades. So lets say we have taken 10 trades in total and 5 of them are profitable, then we would have a strike rate of 5/10 or 50%. This would be the equivalent of flipping a coin. Great, you might think. With a 50/50 chance of getting a winning trade, then I will have plenty of winning trades and all is good.

What may not be immediately obvious though, is that you can still have loosing streaks with a strike rate of 50%. If we take 5 trades there is 1/32 or 3.125% chance that they will all be loosing trades. That is a fairly small risk, you might think, and you would be right. Until you consider, what is the likelihood of having 5 loosing trades in a row over a much larger amount of trades? What about 50 trades, 100, 500 or even 1000 trades? Well, if you were to take 1000 trades, statistically, you could expect to have 32 streaks of 5 losses in a row.

You might be thinking, ‘but wait, I thought each trade was statistically independent from all of my other trades’ and you would be right. The outcome of each trade is independent from the last, however much like each coin toss is independent from the last, you can still calculate the odds of having a streak. Think of a casino, any one flick of the roulette wheel can be a loss, but with the house advantage, over the long run the casino always wins. Another name for the house advantage is called your edge, although that is another topic for another day.

In addition to having loosing streaks, the statistics also play out for having winning streaks. Over a larger sample size of trades, you can expect that you will have periods where it seems like you can’t make a bad decision. Having a basic understanding of the statistics can help you to reduce the ‘God Complex’ that many people start to feel during a winning streak. It makes it easier to manage your psychology when you understand that winning and loosing streaks are a part of the trading career.

In this scenario, you will use a fixed trading account size and calculate the size of all of your positions. You would then recalculate the size of your positions at set frequency or account size. Lets say you have a trading account of $10,000 and you risk 1% per trade. Here you would risk $100 per position. Now lets say you take a loss, so your trading account is now $9,900. With the fixed risk, your next trade would still risk the same $100. You would recalculate your position sizing at a set frequency, of say at the start of every day, week or month. If you had a bad month and your account size is now $9,500, you would adjust you position size to $95 until the next month.

In this scenario you would always risk 1% of your trading account on every position, so you would calculate your position size for each trade. Using the same example, if you had an account of $10,000 you would have your first position risk $100. If you have a win this time and new account balance is $10,500 and the next position would risk $105.

Having effective risk management is by far the most important part of being successful with trading over the long run. While it is possible to flip an account using a large position sizing, the reality is that over the long run you will have a loosing streak. Loosing streaks are a just as much a part of the game as winning streaks, the aim here is to make sure that we are always able to play tomorrow by not blowing our account today.

Of course, if you risk 10% of your trading account on a position and it wins, you will make far more profit than using the 1% risk management, however you are also far more likely to blow your account over the long run. Imagine the psychological effects of 5 losses in a row when you are risking 10% of your capital. Risk management is a key tool to be able to make trading a new way of life.

Vince, R. (2007) The Handbook of Portfolio Mathematics - ISBN-13: 978-0-471-75768-9

Dr David Paul - The Psychology of Trading & Investing