Risk Management
Effective risk management secures profit and limits potential losses and should be an integral part of any trading strategy.
Risk Tolerance
Risk tolerance varies between traders. Some important considerations include:
Financial Situation: How much risk can you afford to take?
Emotional Tolerance: Can you psychologically handle losses?
Investment Goals: High returns often require higher risk.
Time Horizon: Longer investment periods can tolerate more risk.
Knowledge and Experience: Experience can increase risk tolerance.
Diversification: A varied portfolio helps manage risk.
Risk Tolerance should be regularly assessed as circumstances change.
Risk Management Elements
Effective Risk Management is crucial for securing profits and limiting potential losses. Protecting capital should be a primary objective of any trader.
Key considerations when implementing risk management tools included in Lendal software are outlined below. Further details can be found in the respective sections for each element.
Stop Loss
Effective use of Stop Losses limits potential loss on unfavorable trades. Selecting an appropriate price level for a Stop Loss is crucially important. This may depend on multiple factors including:
Market Volatility
Technical Price Levels
Macro Trend
Trading Strategy
Risk-to-Reward Ratio
Risk Tolerance
Strategy Risk Performance
Position Size
See the Stop Loss section for further detail.
Trailing Stop Loss
A Trailing Stop Loss follows favorable price movement by a fixed amount or percentage to protect profit. This allows a position to remain open if price moves favorably and triggers a stop order if the direction reverses.
Consider the following when setting Trailing Stop Losses:
Volatility - trailing distance should be set so a Trailing Stop order is not triggered prematurely by normal volatility.
Technical Analysis - significant price levels such as support/resistance or Fibonacci ratios represent potential points of price reversal.
Risk-Reward - align profit targets with your desired risk-reward ratio.
Trading Strategy - tight Trailing Stops may suit short-term strategies, whereas wide stops may suit long-term trading.
Position Size - larger positions may require wider stop losses to handle market fluctuations.
Risk Tolerance - set stop losses to limit potential losses to match your risk tolerance.
Psychology - Trailing Stops help to maintain discipline and avoid emotional decisions.
See the Trailing Stop Loss section for further detail.
Take Profit
Take Profit orders are an important tool for securing profits on winning trades.
Consider the following when setting Take Profit levels:
Profit Target - set realistic Take Profit levels.
Volatility- adjust Take Profit levels in volatile markets to prevent premature order execution.
Technical Analysis- consider significant price points such as support/resistance or Fibonacci levels when setting orders.
Fundamental Analysis - adjust Take Profit levels based on expected major events.
Risk-Reward - align Take Profit levels with the desired risk-reward ratio.
Trading Strategy - Take Profit orders should align with your trading strategy.
Psychology - Take Profit orders help maintain discipline and avoid emotional decisions.
Broker/Exchange fees - setting fewer orders may be sensible if fees are high relative to profit.
See the Take Profit section for further details.
Scaled Exits
Profit Targets - define realistic exit targets.
Position Size - decide the percentage of your position to be closed at each target. e.g. earlier exits may be proportionally greater to secure profits and reduce risk.
Volatility - In volatile markets, closer exit targets may be advisable to secure profits quickly. In stable trends, broader exit targets may capture more profit.
Technical Analysis - consider significant price points such as support/resistance or Fibonacci levels when setting orders.
Fundamental Analysis - adjust Take Profit levels based on expected major events.
Risk Management - Scaled Exits manage risk by securing profits, but also reduce potential gains if the price continues to move favorably.
Risk-Reward - align Scaled Exit levels with your desired risk-reward ratio.
Psychology - Scaled Exits provide regular profit-taking points and help prevent emotional decisions.
Strategy - Scaled Exit orders should align with your overall trading strategy.
Broker/Exchange fees - setting fewer orders may be sensible if fees are high relative to profit.
See the Scaled Exits section for further details.
Deactivate Risk Management Settings
It may be beneficial to deactivate global risk management settings to simplify optimization initially. This ensures only Faction settings are affecting profitability data displayed in the Strategy Tester Panel.
Risk management elements can be reintroduced once algorithms contributing to a strategy have been optimized. Risk management settings are important for reducing the impact of Drawdowns on Equity and for improving risk performance, as measured by the Sharp Ratio.
Deactivate risk management elements by adjusting the settings below:
Scaled Exits – Evaluation = off
Take Profit – Take Profit Mode = off
Stop Loss – Enable Stop Loss = disabled
Trailing Stop Loss – Enable Trailing Stop Loss = disabled
Sharp Ratio Optimization
The Sharpe Ratio measures the risk per unit of return or 'risk performance' of a strategy. A strategy with a ratio <1 may prove volatile and presents a high risk for the expected return, while a ratio >2.0 indicates lower volatility and risk.
Sharpe Ratio Formula:
Sharpe Ratio = (AR - RFR) / SD, where AR = average return, RFR is the risk-free rate of return, and SD is the standard deviation of returns.
See the Performance Summary section for details on how Sharp Ratio is calculated.
Improving Risk Performance
Improving the risk performance of a strategy is a primary aim of Strategy Optimization. Any optimization that increases daily returns and decreases the variability in returns will increase the Sharp Ratio.
Each Faction contributing to a strategy should be isolated and optimized to boost Net Profit and reduce Max Drawdown. A trade-off between the two is often necessary. It may be beneficial to Deactivate Risk Management Settings and Deactivate Volume Control, Price Control, and Volatility Settings initially to simplify optimization.
Once each Faction is tuned to market conditions, the full Confluence or Super Trends strategy should be optimized to boost Net Profit and reduce Max Drawdown. See the Strategy Optimization section for further details.
Equity, Drawdown, and Sharp Ratio
The Equity and Drawdown charts in the Overview tab are useful for optimization.
Example:
The strategy shown below has a good Net Profit (122.88%) but a large Max Drawdown (24.1%). This high variability in returns generates a low Sharp Ratio (0.7).
Before optimization:
The arrows mark areas of heavy Drawdown (purple bars) and negative impact Equity (green line). Trades with heavy drawdown can be identified on the horizontal axis and examined in the List of Trades and Trades on Chart displays. Details in these displays inform decisions on Strategy Optimization.
After optimization:
After Strategy Optimization the Net Profit (162.88%) has improved and the Max Drawdown (11.1%) has been reduced. Profit Factor (1.91) and Avg Trade (1.45%) have also increased.
The Sharp Ratio (1.82) on the strategy has improved which represents better risk performance. This is reflected in the Overview chart by smaller Drawdowns (purple bars) and a steady increase in Equity (green line).
Sortino Ratio
The Sortino Ratio is a variation of the Sharpe Ratio. It also measures risk per unit of return but focuses exclusively on downside risk. A high Sortino ratio is associated with low downside risk and vice versa.
Sortino Ratio formula:
Sortino Ratio SR = (AR - RFR) / DD, where AR is the actual return, RFR is the risk-free rate of return, and DD is the downside deviation (volatility on negative returns).
Sortino and Sharp Ratio Relationship
The Sharpe Ratio considers volatility in both directions relative to returns. Whereas, the Sortino Ratio measures only downside volatility. Consequently, they do not necessarily increase proportionally.
A highly volatile strategy could have a high Sharp Ratio but still present considerable downside risk. However, the same strategy would return a low Sortino Ratio.
Ideally, an optimized strategy would have a high Sharp and Sortino Ratio.
Leverage and Position Size
Using appropriate Leverage and Position Sizing is essential to maximizing profits and managing risk. Decisions regarding Leverage and Position Size will depend on the Risk Performance of a strategy, Risk Management requirements, and individual Risk Tolerance.
The Lendal Position Calculator allows users to determine the appropriate Leverage, Position Size, and Stop Loss to maximize profit and avoid surpassing a specified maximum account loss. See the Position Calculator section for details.
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