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Turn a Vague Risk Rule Into Numbers

The rule: "Never risk more than I can afford to lose." It sounds responsible. It cannot be checked, because it names no amount.

Rewrite it in steps. Step one, define what you can afford to lose in total. Suppose you have 8,000 dollars of savings beyond emergency funds and expenses, and decide that 3,000 dollars could be lost without affecting your life. That is the trading capital.

Step two, define the maximum acceptable drawdown on it. Perhaps 20 percent, 600 dollars, before you stop and review.

Step three, derive risk per trade from the drawdown and the expected losing streak. If your strategy can produce eight losses in a row, and you want that to cost no more than half your drawdown limit, 10 percent of capital, the risk per trade is 10 divided by 8, about 1.25 percent. Round down to 1 percent, or 30 dollars per trade.

Step four, daily and weekly limits. A daily limit of 2 percent, 60 dollars. A weekly limit of 4 percent, 120 dollars.

Step five, total open risk: no more than 2 percent, 60 dollars, across all positions.

Step six, the action rules. At a 10 percent drawdown, halve the risk. At 20 percent, stop and review for two weeks.

Now the rule can be checked every day, by looking at numbers.

Compare. The vague rule is satisfied by almost any behavior. The numeric rule is violated by specific actions.

Exercise: rewrite your own risk rule using these six steps.

Step three is the clever part, deriving risk per trade from the drawdown limit and a realistic losing streak. It's worth checking the streak assumption with data. At a 40 percent win rate, the chance of eight losses in a row in any given sequence of eight trades is 0.6 to the eighth, about 1.7 percent. Over a few hundred trades, a streak of that length becomes fairly likely to occur at least once. Using a simulation or your own trade history to find the longest streak you'd expect over a year makes the number more grounded than a guess.

I tried to rewrite my own rule this way about a year ago, and the first surprise was how uncomfortable step one is. When I sat down and asked what I could lose without it affecting my life, the honest number was less than half what I'd been trading with. I'd been calling the larger figure my risk capital for years because the vague rule never forced me to check.

Step three was the most useful for me as well, but I'd test the losing streak figure against your own journal rather than a guess. My longest run was seven in a row, and it arrived during a week where I'd already sized up after a good month. So I now treat the streak length as at least one more than my worst so far.

The action rules in step six are what keep it honest. Mine says that after a 10 percent drawdown I halve size automatically, and I've written that on a card next to the monitor so I don't negotiate with myself in the moment.