Money Management
Statistically, two out of every three trades will trigger the stoploss.
Let us now calculate the linear expectancy for a few R/r ratio setups in purely
random markets. The probabilities of a stoploss being taken out for one-to-one,
two‐to‐one, and three‐to‐one R/r ratio setups are one out of two (50%), two out
of three (66.6%), and three out of four (75%), respectively.a. For R/r→1:1:
Linear Exp = (R × win ratio) − (r × loss ratio)
(1 × 0.5) − ($1 × 0.5) = 0
b. For R/r →2:1:
Linear Exp = (R × win ratio) − (r × loss ratio)
= (2 × 1/3) − (1 × 2/3) = 0
c. For R/r →3:1:
Linear Exp = ($R × w) − ($r × l)
= ($3 × 1/4) − ($1 × 3/4) = 0We therefore observe that irrespective of the R/r ratio setup being em-
ployed, there is no real edge in using a higher R/r ratio in purely random
markets over the very long term. But R/r ratios react differently in real or
semi‐random markets. This is because there are fairly consistent underlying
behavioral patterns that do not occur in random systems. One such behavioral
pattern is the phenomenon of overextension in the markets. Conditions of be-
ing overbought or oversold exist because of human tendencies associated with
emotions such as fear, greed, and hope. Such conditions are also the result of
human biases and psychology with respect to risking capital and profit in the
markets. Another such behavioral pattern is the phenomenon of persistent
trends driven by irrational buying and selling. Therefore, the trader will need
to be able to identify these behavioral patterns and participate at the most ap-
propriate moment.the effect of asymmetry in risksizing
There are basically two ways to allocate capital to a trade, also called risksizing,
namely:- To allocate a fixed %risk per trade based on original or initial capital
- To allocate a fixed %risk per trade based on current capital
Allocating a fixed %risk per trade based on original or initial capital is re-
ferred to as fixed sizing while allocating a fixed %risk per trade based on initial
capital is referred to as dynamic sizing. Let us now calculate the average profit
and loss for a scenario with five wining trades and five losing trades based on the
fixed‐sizing approach. Average profit and loss based on fixed sizing is referred
to as linear expectancy. Assume that we have a one‐to‐one R/r ratio setup with
%win of 50 percent over 20 trades, that is, T = 20.