**LIQUIDITY**

One of the assumptions I used
to have about trading was that things worked in
a linear fashion. What I mean by this is if someone could turn
£1,000 into £10,000 then they could easily turn
£10,000 into £100,000. If they could easily turn
£100,000 into £1 million then they could easily
turn £1 million into £10 million. However I
eventually came to an understanding that things
don't work in a linear fashion.

One of the reasons why being
able to increase an account 10 times is much
more difficult as you increase your position
size is not only because ones emotional response to increasing position
size can significantly affect decision making, but even more impacting is that the higher
your position size the slower it can take for your order to be taken especially if
you are dealing in a market where the liquidity
is patchy. Sometimes depending on the type of
trade you are executing speed could be of
significance where a £10,000 order is filled in
1 second but a £100,000 order could take 5-20
seconds in which there is more exposure to the
possibility of market moves which could cause your
order to be left unfilled.

So one of the big important
truths about successful trading is ensuring you
operate in markets where there is sufficient
liquidity for your trades to be opened and
closed quickly if you are operating trades where
speed is needed. When I began to see evidence
that my trading strategy had evolved to where I
would be making profit consistently I began trading in markets where
liquidity was patchy. This resulted in a
number of situations where I was unable to close
trades as the market had moved against me whilst
I was waiting endlessly for my trade to be taken
because there simply wasn't enough money in the
market.

Consequentially I had to
close out my position at a significant loss or I
would have completely lost all the size I had
put on.

However if you observe and
respect the nature of liquidity in the markets
you operate in then one of the greatest benefits
of trading is scalability. This means as your
bank starts to increase you can then increase
your position size to generate accelerated
profits.

**RISK
MANAGEMENT **

There is no secret that the
key to your income in trading is your trading
account (bank). Your
bank is a fundamental component of your
trading success. Unfortunately I did not respect
this during the early part of my trading history
which is why I would blow through a number of
trading accounts as a consequence of poor risk
and money management. Now I operate with a fundamental
rule that I trade no more than 2% of my bank on
any 1 trade but I also found it important to
have an exposure limit per day. My overall
portfolio exposure limit per day is no more than
6% of my
bank. So on an account of £5,000 if I hit around
a
£300 loss in any one day then that is my
stop loss to stop trading for that day. Bear in mind
that due to the positive expectancy of my
strategy that I can go on a winning run where I
can make over £1500 per day (providing there are a
sufficient high probability trades to take) so my loss potential is limited and
restrained but my reward potential on an
individual day can be over twice as much.

**RISK
OF RUIN**

One of the other concepts of
great importance is the "risk of ruin". Risk of
ruin is the probability that you’ll lose so much
money you can no longer continue trading. This
doesn’t mean losing all of your trading capital,
the ruin point is based on your own personal
risk tolerance, so ruin to you could be 15%, it
could be 50% or it could be 100% of your trading
capital.

It is imperative that you
know what your risk is and are willing to
embrace it. if you are not willing to take any
risk on your account, then you cannot trade, it
is as simple as that. Ideally you should be
willing to risk at least 25-30% of your account
as a maximum drawdown\point of ruin before you
must stop trading, and then review your
business\trading plan for new objectives and
risk parameters to determine if you can still
trade, then build a new plan if required.

As traders our job is to avoid reaching our
point of ruin. So you must work out your
probability of reaching this level of
drawdown.

There is a formula for working out your risk of
ruin, and ideally you risk of ruin should be
between 0 % – 0.5%. NOTE: It is mathematically
impossible for the risk of ruin being 0.0
percent! So the aim is below 0.5%, which when
rounded down is 0%. When you get above 1% and
higher that’s when you know you are risking too
much, and the risk of ruin is becoming positive,
meaning that its only a matter of time before
you reach your maximum draw down
level! Therefore it is advised that you do not trade until you are comfortable that you can
perform (With simulated trading if you are a
discretionary trader or on a back-test for an
automated system) at a level where risk of ruin
is less than 0.5% and ideally towards 0% as
possible.

There are a number of ways to calculate Risk of
Ruin, however the most common formula is:

Risk of Ruin = (1-(W-L))/(1+(W-L))^ U

(Where W=Probability of
winning, L+ Probability of Losing, ^ denoted the
power of U + Number of Maximum Risk Trades that
may be taken).

*Here is an example of trader A with a $50,000
account and is willing to Risk a Maximum
drawdown of 30%, which is a Point of Ruin at
-$15,000. Lets assume Trader A has proven
through his trading that he can gain the
following averages: Win% = 60%, Loss% = 40%,
Risk per trade is 1% of full account at $500 so
max trades he may take and lose sequentially is
30 trades before he reaches the Point of Ruin
(Max Drawdown).*

So his Risk of Ruin is worked out as follows:

(1-(0.2)/1+(0.2))^30 =

(0.8/1.2)^30 =M

(0.666666)^30 = 0.000005214 = 0% (When rounded
down).

Which is a very low risk of ruin! This allows
for this trader to take risk comfortably knowing
that there is very little chance of ruin. Of
course this assumes that the trader keeps
performing well! If the win rate and win to loss
ratio adjusts over time the risk of ruin may
increase\decrease.

*Now lets consider Trader B who takes too much
risk and is under-capitalised. He has a $10,000
account and is willing to Risk a Maximum
drawdown of 30%, which is a Point of Ruin at
-$3000. Win% = 60%, Loss% = 40%, Risk per trade
is 10% of full account at $1000 so max trades he
may take and lose sequentially is 3 trades
before he reaches the Point of Ruin (Max
Drawdown).*

So his Risk of Ruin is worked out as follows

(1-(0.2)/1+(0.2))^3 =

(0.8/1.2)^3 =

(0.666666)^3 = 0.2962954074083 = 30% (Rounded
up)

That’s a big difference, with the same technical
performance but a smaller account and more risk.
Trader B has a high chance of ruin.

Our main job as traders should be to reduce any
chance of ruin. Any probability in favour of
ruin is not good! You as the trader are in
control of your risk of ruin. Therefore it’s
essential to position size and manage risk
accordingly for each trade and every day so that
risk is minimal, and risk of ruin is kept to the
minimal.

So lets consider the ways that you can reduce
your risk of ruin:

1. Increase your accuracy and obtain a higher
win%.

2. Increase your average win to average loss
ratio.

3. Reduce the amount of money risked per trade
and per day by trading more capital or taking
less risk per trade\day.

**POSITION SIZING**

The other thing I would
mention is what when increasing position sizing
as your account grows do it in small sequential
stops. As humans we have the unique ability to
increase our position sizing over and beyond
what we should at a time when the market is at
its most vicious which then leads to significant
loss, emotional torment and the undoing of all
the good work that may have taken months to
produce.

It may come as a surprise to many traders that
adding to position size can be devastating to
their trading success and their overall dream of
becoming a trader. Increasing the position size
at the wrong times or adding in wrong increments
can affect the traders mindset in such a way
that it can, in a matter of days, ruin all the
hard work the trader has done over a long period
of time.

When increasing the position size there are two
very important things to take into
consideration; when is the right time to
increase the position size and how much should
the trader increase with?

Before answering this
question it is important to understand that
trading is about the bigger picture, meaning
that success and profitability is measured over
a series of trades, e.g. 30-50 trades. This is to
help the trader stay focused and disciplined and
also gives you ways to improve your mindset.
Just because the trader loses money on one trade
does not mean that the system is not profitable.
It is either about having a hit rate above 50%
or about making more money on the winners than
the trader is losing on the losers. This series
of trades is therefore very important to follow
when considering increasing the position size.

The answer to the first part of the question
above is that you should never consider
increasing in the middle of a string of trades.
Do not just add after a few winning trades. A
common mistake new traders make is adding to
position after a few winners only to get stopped
out on the next trade and thereby lose all
previous profit. This frustrates the trader who
then scraps this system believing that the
system must be bad and therefore searches for a
new system resulting in a vicious circle. The
truth is, the system might have been good but
the trader will never find out. Always make sure
that the system works over a longer series of
trades. Set that number before starting to trade
and use that same number consistently.

So, when exactly should you increase the
position size in order to start becoming a
winning trader? The trader should only increase
the size after the series of the predetermined
trades in order to be sure that the system is
still profitable. I trade around 130 times per
month times and if
overall those trades are profitable as a whole I can then
increase my position size. Notice I wrote that I
can increase, but I do not necessarily need to.
I still need to be comfortable when trading, and
this brings me to the next question: how much
should the trader increase with? This is another
place where new traders make mistakes. Always
increase in the minimum size possible. This is
to avoid too bigger swings in the mindset. After
the trader has taken over 100 trades in a row they are
used to the swings the trades will
experience.

When increasing the position size
the liability will suddenly be bigger and might
make the trader nervous so they might not take
the next trade after a loss or might exit the
trade premature. The trader cannot avoid this
completely as they have to increase the size but
can limit it by adding in small increments.
Another reason why the trader should increase in
small increments is that many traders make big
position sizing leaps and when they get stopped out
they see that they have lost a lot more than
they made by trading the previous position
sizing.
This can result in completely stopping trading
this system believing that the system is bad.
Then the trader is back to the above mentioned
vicious circle.